NFLX-06.30.13-10Q-DOC
Table of Contents

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 June 30, 2013
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: 000-49802
 
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 June 30, 2013, there were 58,922,493 shares of the registrant’s common stock, par value $0.001, outstanding.



Table of Contents

Table of Contents
 
 
 
Page
 
Part I. Financial Information
 
Item 1.
Consolidated Financial Statements
 
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
Part II. Other Information
Item 1.
Item 1A.
Item 6.
 
 


2

Table of Contents

NETFLIX, INC.

Consolidated Statements of Operations
(unaudited)
(in thousands, except per share data)

 
Three Months Ended
 
Six Months Ended
 
June 30,
2013
 
June 30,
2012
 
June 30,
2013
 
June 30,
2012
Revenues
$
1,069,372

 
$
889,163

 
$
2,093,333

 
$
1,758,954

Cost of revenues
753,525

 
643,428

 
1,480,388

 
1,267,361

Marketing
121,760

 
113,964

 
250,935

 
243,892

Technology and development
93,126

 
81,547

 
185,101

 
164,348

General and administrative
43,844

 
34,070

 
87,970

 
69,134

Operating income
57,117

 
16,154

 
88,939

 
14,219

Other income (expense):
 
 
 
 
 
 
 
Interest expense
(7,528
)
 
(5,006
)
 
(14,268
)
 
(9,980
)
Interest and other income (expense)
(2,940
)
 
(493
)
 
(1,963
)
 
(609
)
Loss on extinguishment of debt

 

 
(25,129
)
 

Income before income taxes
46,649

 
10,655

 
47,579

 
3,630

Provision for income taxes
17,178

 
4,491

 
15,419

 
2,050

Net income
$
29,471

 
$
6,164

 
$
32,160

 
$
1,580

Earnings per share:
 
 
 
 
 
 
 
Basic
$
0.51

 
$
0.11

 
$
0.56

 
$
0.03

Diluted
$
0.49

 
$
0.11

 
$
0.53

 
$
0.03

Weighted average common shares outstanding:
 
 
 
 
 
 
 
Basic
58,192

 
55,526

 
57,089

 
55,491

Diluted
60,590

 
58,809

 
60,369

 
58,878












See accompanying notes to the consolidated financial statements.


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Table of Contents


NETFLIX, INC.
Consolidated Statements of Comprehensive Income
(unaudited)
(in thousands)
 
Three Months Ended
 
Six Months Ended
 
June 30,
2013
 
June 30,
2012
 
June 30,
2013
 
June 30,
2012
Net income
$
29,471

 
$
6,164

 
$
32,160

 
$
1,580

Other comprehensive income (loss):
 
 
 
 
 
 
 
Foreign currency translation adjustments 
30

 
(767
)
 
(2,259
)
 
44

Change in unrealized gains (losses) on available-for-sale securities, net of tax of $(1,239), $95, $(1,451), and $133, respectively
(1,985
)
 
151

 
(2,324
)
 
211

Total other comprehensive income (loss)
(1,955
)
 
(616
)
 
(4,583
)
 
255

Comprehensive income
$
27,516

 
$
5,548

 
$
27,577

 
$
1,835






















See accompanying notes to the consolidated financial statements.

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Table of Contents

NETFLIX, INC.

Consolidated Statements of Cash Flows
(unaudited)
(in thousands)
   
Three Months Ended
 
Six Months Ended
   
June 30,
2013
 
June 30,
2012
 
June 30,
2013
 
June 30,
2012
Cash flows from operating activities:
 
 
 
 
 
 
 
Net income
$
29,471

 
$
6,164

 
$
32,160

 
$
1,580

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 
 
 
Additions to streaming content library
(593,454
)
 
(374,252
)
 
(1,185,395
)
 
(1,139,145
)
Change in streaming content liabilities
7,284

 
(39,947
)
 
16,984

 
357,606

Amortization of streaming content library
510,250

 
375,997

 
995,990

 
715,733

Amortization of DVD content library
17,709

 
16,304

 
35,946

 
36,350

Depreciation and amortization of property, equipment and intangibles
12,026

 
11,047

 
24,077

 
22,378

Stock-based compensation expense
17,955

 
18,450

 
35,701

 
37,782

Excess tax benefits from stock-based compensation
(20,368
)
 
(307
)
 
(31,983
)
 
(4,062
)
Other non-cash items
1,188

 
(1,579
)
 
2,938

 
(3,098
)
Loss on extinguishment of debt

 

 
25,129

 

Deferred taxes
(2,040
)
 

 
(8,788
)
 
(10,843
)
Changes in operating assets and liabilities:
 
 
 
 
 
 
 
Prepaid content
25,190

 
4,503

 
27,865

 
7,497

Other current assets
8,572

 
(8,077
)
 
170

 
3,664

Accounts payable
(5,138
)
 
316

 
11,881

 
(1,440
)
Accrued expenses
10,494

 
6,854

 
6,362

 
8,637

Deferred revenue
7,693

 
2,188

 
17,099

 
3,994

Other non-current assets and liabilities
7,111

 
1,746

 
15,557

 
1,883

Net cash provided by operating activities
33,943

 
19,407

 
21,693

 
38,516

Cash flows from investing activities:
 
 
 
 
 
 
 
Acquisitions of DVD content library
(14,023
)
 
(8,012
)
 
(35,216
)
 
(21,540
)
Purchases of property and equipment
(8,088
)
 
(3,359
)
 
(20,206
)
 
(8,125
)
Other assets
1,087

 
3,132

 
5,137

 
4,466

Purchases of short-term investments
(146,050
)
 
(63,303
)
 
(381,673
)
 
(362,770
)
Proceeds from sale of short-term investments
33,979

 
48,173

 
115,207

 
220,508

Proceeds from maturities of short-term investments
5,410

 
12,715

 
9,830

 
20,990

Net cash used in investing activities
(127,685
)
 
(10,654
)
 
(306,921
)
 
(146,471
)
Cash flows from financing activities:
 
 
 
 
 
 
 
Proceeds from issuance of common stock
28,846

 
524

 
67,992

 
1,748

Proceeds from issuance of debt

 

 
500,000

 

Issuance costs

 
(371
)
 
(9,414
)
 
(759
)
Redemption of debt

 

 
(219,362
)
 

Excess tax benefits from stock-based compensation
20,368

 
307

 
31,983

 
4,062

Principal payments of lease financing obligations
(255
)
 
(577
)
 
(658
)
 
(1,136
)
Net cash provided by (used in) financing activities
48,959

 
(117
)
 
370,541

 
3,915

Effect of exchange rate changes on cash and cash equivalents
(2,590
)
 
(2,377
)
 
(4,926
)
 
(1,762
)
Net (decrease) increase in cash and cash equivalents
(47,373
)
 
6,259

 
80,387

 
(105,802
)
Cash and cash equivalents, beginning of period
418,051

 
395,992

 
290,291

 
508,053

Cash and cash equivalents, end of period
$
370,678

 
$
402,251

 
$
370,678

 
$
402,251

See accompanying notes to the consolidated financial statements.

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Table of Contents

NETFLIX, INC.
Consolidated Balance Sheets
(in thousands, except share and par value data)

 
As of
   
June 30,
2013
 
December 31,
2012
 
(unaudited)
 
 
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
370,678

 
$
290,291

Short-term investments
709,432

 
457,787

Current content library, net
1,363,609

 
1,368,162

Prepaid content
32,064

 
59,929

Other current assets
94,539

 
64,622

Total current assets
2,570,322

 
2,240,791

Non-current content library, net
1,682,202

 
1,506,008

Property and equipment, net
127,931

 
131,681

Other non-current assets
100,296

 
89,410

Total assets
$
4,480,751

 
$
3,967,890

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Current content liabilities
$
1,321,217

 
$
1,366,847

Accounts payable
103,441

 
86,468

Accrued expenses
59,035

 
53,139

Deferred revenue
186,571

 
169,472

Total current liabilities
1,670,264

 
1,675,926

Non-current content liabilities
1,124,249

 
1,076,622

Long-term debt
500,000

 
200,000

Long-term debt due to related party

 
200,000

Other non-current liabilities
80,616

 
70,669

Total liabilities
3,375,129

 
3,223,217

Commitments and contingencies (Note 10)


 


Stockholders’ equity:
 
 
 
Common stock, $0.001 par value; 160,000,000 shares authorized at June 30, 2013 and December 31, 2012; 58,922,493 and 55,587,167 issued and outstanding at June 30, 2013 and December 31, 2012, respectively
59

 
56

Additional paid-in capital
634,985

 
301,616

Accumulated other comprehensive (loss) income
(1,664
)
 
2,919

Retained earnings
472,242

 
440,082

Total stockholders’ equity
1,105,622

 
744,673

Total liabilities and stockholders’ equity
$
4,480,751

 
$
3,967,890

See accompanying notes to the consolidated financial statements.
 

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Table of Contents

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, 2012 filed with the Securities and Exchange Commission (the “SEC”) on February 1, 2013. 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 amortization policy for the streaming content library; 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. 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, 2012. Interim results are not necessarily indicative of the results for a full year.
The Company is organized into three operating segments: Domestic streaming, International streaming and Domestic DVD. 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, 2012.

2. Reclassifications
Certain prior period amounts have been reclassified to conform to the current period presentation in the Consolidated Statements of Operations. Payroll and related expenses of $4.3 million and $10.2 million for the three and six months ended June 30, 2012, respectively, associated with corporate marketing personnel, previously classified in "Marketing" on the Consolidated Statements of Operations, have been reclassified as "General and administrative". Historically these costs were substantially recorded in the Domestic streaming segment and impacted segment contribution profit. Management and the Company's chief operating decision maker consider such employee costs to be global corporate costs rather than direct marketing costs and as such are not indicative of any given segment's performance. Accordingly, such costs have been reclassified as "General and administrative" expenses which are not a component of contribution profit. There was no impact to operating income in any period.
In addition, certain prior period amounts in the Consolidated Statements of Cash Flows have been revised to correctly present changes in accounts payable related to purchases of fixed assets. For the three and six months ended June 30, 2012, a $0.3 million increase in accounts payable has been reclassified from purchases of fixed assets in "Net cash used in investing activities" to changes in accounts payable in "Net cash provided by operating activities". There was no impact to the Consolidated Statements of Operations or Consolidated Balance Sheets.

3. Earnings Per Share
Basic earnings per share is computed using the weighted-average number of outstanding shares of common stock during the period. Diluted earnings per share is computed using the weighted-average number of outstanding shares of common stock and, when dilutive, potential common shares outstanding during the period. Potential common shares consist of shares issuable upon the assumed conversion of the Company’s Senior Convertible Notes (prior to the conversion of such notes) and incremental shares issuable upon the assumed exercise of stock options. The computation of earnings per share is as follows:


7

Table of Contents

 
Three Months Ended
 
Six Months Ended
 
June 30,
2013
 
June 30,
2012
 
June 30,
2013
 
June 30,
2012
 
(in thousands, except per share data)
Basic earnings per share:
 
 
 
 
 
 
 
Net income
$
29,471

 
$
6,164

 
$
32,160

 
$
1,580

Shares used in computation:
 
 
 
 
 
 
 
Weighted-average common shares outstanding
58,192

 
55,526

 
57,089

 
55,491

Basic earnings per share
$
0.51

 
$
0.11

 
$
0.56

 
$
0.03

 
 
 
 
 
 
 
 
Diluted earnings per share:
 
 
 
 
 
 
 
Net income
$
29,471

 
$
6,164

 
$
32,160

 
$
1,580

Senior Convertible Notes interest expense, net of tax

 
48

 
49

 
98

Numerator for diluted earnings per share
$
29,471

 
$
6,212

 
$
32,209

 
$
1,678

Shares used in computation:
 
 
 
 
 
 
 
Weighted-average common shares outstanding
58,192

 
55,526

 
57,089

 
55,491

Senior Convertible Notes shares
564

 
2,331

 
1,442

 
2,331

Employee stock options
1,834

 
952

 
1,838

 
1,056

Weighted-average number of shares
60,590

 
58,809

 
60,369

 
58,878

Diluted earnings per share
$
0.49

 
$
0.11

 
$
0.53

 
$
0.03


Employee stock options with exercise prices greater than the average market price of the common stock were excluded from the diluted calculation as their inclusion would have been anti-dilutive. The following table summarizes the potential common shares excluded from the diluted calculation:

 
Three Months Ended
 
Six Months Ended
 
June 30,
2013
 
June 30,
2012
 
June 30,
2013
 
June 30,
2012
 
(in thousands)
Employee stock options
318

 
1,184

 
384

 
908


4. Short-term Investments
The Company’s investment policy is consistent with the definition of available-for-sale securities. The Company does not buy and hold securities principally for the purpose of selling them in the near future. The Company’s policy is focused on the preservation of capital, liquidity and 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 table summarizes, 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:
 
As of June 30, 2013
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
(in thousands)
Cash
$
368,527

 
$

 
$

 
$
368,527

Level 1 securities:
 
 
 
 
 
 
 
Money market funds
7,354

 

 

 
7,354

Level 2 securities:
 
 
 
 
 
 
 
Corporate debt securities
332,174

 
918

 
(1,714
)
 
331,378

Government and agency securities
181,638

 
180

 
(156
)
 
181,662

Asset and mortgage-backed securities
196,913

 
276

 
(797
)
 
196,392

Total (1)
$
1,086,606

 
$
1,374

 
$
(2,667
)
 
$
1,085,313


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As of December 31, 2012
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
 
(in thousands)
Cash
$
284,661

 
$

 
$

 
$
284,661

Level 1 securities:
 
 
 
 
 
 
 
Money market funds
10,500

 

 

 
10,500

Level 2 securities:
 
 
 
 
 
 
 
Corporate debt securities
150,322

 
1,605

 
(32
)
 
151,895

Government and agency securities
166,643

 
285

 

 
166,928

Asset and mortgage-backed securities
138,340

 
750

 
(125
)
 
138,965

Total (2)
$
750,466

 
$
2,640

 
$
(157
)
 
$
752,949

(1)
Includes $370.7 million that is included in cash and cash equivalents, $709.4 million included in short-term investments and $5.2 million of restricted cash that is included in other non-current assets related to workers compensation deposits.
(2)
Includes $290.3 million that is included in cash and cash equivalents, $457.8 million included in short-term investments and $4.8 million of restricted cash that is included in other non-current assets related to workers compensation deposits.

Fair value is a market-based measurement that is determined based on the assumptions that market participants would use in pricing an asset or liability. The hierarchy level assigned to each security in the Company’s available-for-sale portfolio and cash equivalents is based on its assessment of the transparency and reliability of the inputs used in the valuation of such instrument at the measurement date. The fair value of available-for-sale securities and cash equivalents included in the Level 1 category is based on quoted prices that are readily and regularly available in an active market. The fair value of available-for-sale securities included in the Level 2 category is based on observable inputs, such as quoted prices for similar assets at the measurement date; quoted prices in markets that are not active; or other inputs that are observable, either directly or indirectly. These values were obtained from an independent pricing service and were evaluated using pricing models that vary by asset class and may incorporate available trade, bid and other market information and price quotes from well-established independent pricing vendors and broker-dealers. The Company's procedures include controls to ensure that appropriate fair values are recorded, such as comparing prices obtained from multiple independent sources. See Note 6 to the consolidated financial statements for further information regarding the fair value of the Company’s debt instruments.
Because the Company does not intend to sell the investments that are in an unrealized loss position and it is not likely that the Company will be required to sell any investments before recovery of their amortized cost basis, the Company does not consider those investments with an unrealized loss to be other-than-temporarily impaired at June 30, 2013. There were no investments in an unrealized loss position for longer than 12 months as of June 30, 2013 or December 31, 2012, respectively. There were no material other-than-temporary impairments or credit losses related to available-for-sale securities in the three and six months ended June 30, 2013 and 2012. In addition, there were no material gross realized gains or losses in the three and six months ended June 30, 2013 and 2012.
The estimated fair value of short-term investments by contractual maturity as of June 30, 2013 is as follows:
 
 
(in thousands)
Due within one year
$
138,342

Due after one year and through 5 years
524,210

Due after 5 years and through 10 years
1,755

Due after 10 years
45,125

Total short-term investments
$
709,432


5. Balance Sheet Components
Content Library
Content library consisted of the following:
 

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As of
 
June 30,
2013
 
December 31,
2012
 
(in thousands)
Total content library, gross
$
5,519,593

 
$
5,001,524

Accumulated amortization
(2,473,782
)
 
(2,127,354
)
Total content library, net
3,045,811

 
2,874,170

Current content library, net
1,363,609

 
1,368,162

Non-current content library, net
$
1,682,202

 
$
1,506,008


Property and Equipment, Net
Property and equipment and accumulated depreciation consisted of the following:

 
 
 
As of
 
 
 
June 30,
2013
 
December 31,
2012
 
 
 
(in thousands)
Computer equipment
 
3 years
$
92,922

 
$
84,193

Operations and other equipment
 
5 years
99,153

 
100,207

Software
 
3 years
39,089

 
39,073

Furniture and fixtures
 
3 years
19,073

 
18,208

Building
 
30 years
40,681

 
40,681

Leasehold improvements
 
Over life of lease
46,839

 
45,393

Capital work-in-progress
 
 
9,947

 
8,282

Property and equipment, gross
 
 
347,704

 
336,037

Less: Accumulated depreciation
 
 
(219,773
)
 
(204,356
)
Property and equipment, net
 
 
$
127,931

 
$
131,681


6. Long-term Debt
Senior Convertible Notes
In November 2011, the Company issued $200.0 million aggregate principal amount of zero coupon Senior Convertible Notes due on December 1, 2018 (the “Convertible Notes”) in a private placement offering to TCV VII, L.P., TCV VII(A), L.P. and TCV Member Fund, L.P. A general partner of these funds also serves on the Company’s Board of Directors, and as such, the issuance of the notes was considered a related party transaction. At any time following May 28, 2012, the Company may have elected to cause the conversion of the Convertible Notes into shares of the Company’s common stock when specified conditions are satisfied, including that the daily volume weighted average price of the Company’s common stock was equal to or greater than $111.54 for at least 50 trading days during a 65 trading day period prior to the conversion date.
In April 2013, after all specified conditions were satisfied, the Company elected to cause the conversion of all outstanding Convertible Notes with an aggregate principal amount of $200.0 million in accordance with the terms of the Indenture governing such notes. Pursuant to this conversion, the Company issued 2.3 million shares of common stock to the holders of the Convertible Notes at a conversion ratio of 11.6553. The fair market value of one share of common stock on the date of conversion was $216.99 per share.
Senior Notes
In February 2013, the Company issued $500.0 million aggregate principal amount of 5.375% Senior Notes due 2021 (the "5.375% Notes"). The 5.375% Notes were issued at par and are senior unsecured obligations of the Company. Interest is payable semi-annually at a rate of 5.375% per annum on February 1 and August 1 of each year, commencing on August 1, 2013. The 5.375% 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 5.375% Notes prior to maturity in whole or in part at an amount equal to the principal amount thereof plus accrued and unpaid interest plus a make-whole payment equivalent to the present value of the remaining interest payments through maturity.

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Table of Contents

The 5.375% 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 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.
In the first quarter of 2013, the Company used $224.5 million of the net proceeds of the 5.375% Notes to redeem the outstanding $200.0 million aggregate principal amount of 8.50% Senior Notes due 2017 (the “8.50% Notes”) and pursuant to the make-whole provision in the Indenture governing the 8.50% Notes, paid a $19.4 million premium and $5.1 million of accrued and unpaid interest. The Company recognized a loss on extinguishment of debt of $25.1 million related to redemption of the 8.50% Notes which included the write off of unamortized debt issuance costs of $4.2 million.
Based on quoted market prices in less active markets (a Level 2 input for this financial instrument), the fair value of the 5.375% Notes as of June 30, 2013 was approximately $497.5 million.

7. Stockholders’ Equity
In April 2013, the Company issued 2.3 million shares of common stock in connection with the conversion of the Convertible Notes. See Note 6 to the consolidated financial statements for further details.
Preferred Stock
In 2012, the Company designated 1,000,000 shares of its preferred stock with par value of $0.001 per share as Series A Participating Preferred Stock. The remaining 9,000,000 shares of preferred stock with par value of $0.001 remain undesignated. None of the preferred shares were issued and outstanding at June 30, 2013 or December 31, 2012.
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 June 30, 2013, 3.6 million shares were reserved for future grants under the 2011 Stock Plan.
A summary of the activities related to the Company’s stock option plans is as follows:
 
 
 
 
Options Outstanding
 
 
 
 
 
Shares
Available
for Grant
 
Number of
Shares
 
Weighted-
Average
Exercise Price
 
Weighted-Average
Remaining
Contractual Term
(in Years)
 
Aggregate
Intrinsic Value
(in Thousands)
Balances as of December 31, 2012
4,049,037

 
4,572,952

 
$
71.33

 
 
 
 
Granted
(406,292
)
 
406,292

 
162.52

 
 
 
 
Exercised


 
(1,004,266
)
 
67.70

 
 
 
 
Balances as of June 30, 2013
3,642,745

 
3,974,978

 
81.57

 
6.49
 
$
524,708

Vested and exercisable at June 30, 2013
 
 
3,974,978

 
81.57

 
6.49
 
$
524,708


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 second quarter of 2013 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 June 30, 2013. This amount changes based on the fair market value of the Company’s common stock. The total intrinsic value of options exercised for the three months ended June 30, 2013 and 2012 was $68.3 million and $1.0 million, respectively. The total intrinsic value of options exercised for the six months ended June 30, 2013 and 2012 was $118.3 million and $12.8 million, respectively.
Cash received from option exercises for the three months ended June 30, 2013 and 2012 was $28.8 million and $0.5 million, respectively. Cash received from option exercises for the six months ended June 30, 2013 and 2012 was $68.0 million and $1.7 million, respectively.
Stock-Based Compensation
Vested stock options granted before June 30, 2004 can be exercised up to three months following termination of employment. Vested stock options granted after June 30, 2004 and before January 1, 2007 can be exercised up to one year following termination of employment. Vested stock options granted on or after January 1, 2007 will remain exercisable for the full ten year contractual term regardless of employment status.
The following table summarizes the assumptions used to value stock option grants using the lattice-binomial model:

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Table of Contents


 
Three Months Ended
 
Six Months Ended
 
June 30,
2013
 
June 30,
2012
 
June 30,
2013
 
June 30,
2012
Dividend yield
%
 
%
 
%
 
%
Expected volatility
53
%
 
61
%
 
53% - 54%

 
61% - 65%

Risk-free interest rate
1.88
%
 
2.01
%
 
1.87% - 1.88%

 
1.97% - 2.01%

Suboptimal exercise factor
2.39 - 3.61

 
2.26 - 3.65

 
2.33 - 3.61

 
2.26 - 3.65


The Company bifurcates its option grants into two employee groupings (executive and non-executive) based on exercise behavior and considers several factors in determining the estimate of expected term for each group, including the historical option exercise behavior, the terms and vesting periods of the options granted.
The weighted-average fair value of employee stock options granted during the three months ended June 30, 2013 and 2012 was $110.67 and $45.38 per share, respectively. The weighted-average fair value of employee stock options granted during the six months ended June 30, 2013 and 2012 was $87.87 and $50.11 per share, respectively.
Stock-based compensation expense related to stock option plans was $18.0 million and $18.5 million for the three months ended June 30, 2013 and 2012, respectively. Stock-based compensation expense related to stock option plans was $35.7 million and $37.8 million for the six months ended June 30, 2013 and 2012, respectively. The total income tax benefit recognized in the income statement related to stock option plans was $6.9 million and $7.1 million for the three months ended June 30, 2013 and 2012, respectively. The total income tax benefit recognized in the income statement related to stock option plans was $13.7 million and $14.6 million for the six months ended June 30, 2013 and 2012, respectively.


8. Accumulated Other Comprehensive Income

The following tables summarize the changes in accumulated balances of other comprehensive income (loss), net of tax for the three and six months ended June 30, 2013:
 
Foreign currency items
 
Change in unrealized gains on available for sale securities
 
Total
 
(in thousands)
Balance as of March 31, 2013
$
(908
)
 
$
1,199

 
$
291

Other comprehensive income before reclassifications
30

 
(2,068
)
 
(2,038
)
Amounts reclassified from accumulated other comprehensive income

 
83

 
83

Net increase (decrease) in other comprehensive income
30

 
(1,985
)
 
(1,955
)
Balance as of June 30, 2013
$
(878
)
 
$
(786
)
 
$
(1,664
)

 
Foreign currency items
 
Change in unrealized gains on available for sale securities
 
Total
 
(in thousands)
Balance as of December 31, 2012
$
1,381

 
$
1,538

 
$
2,919

Other comprehensive income before reclassifications
(2,259
)
 
(2,363
)
 
(4,622
)
Amounts reclassified from accumulated other comprehensive income

 
39

 
39

Net decrease in other comprehensive income
(2,259
)
 
(2,324
)
 
(4,583
)
Balance as of June 30, 2013
$
(878
)
 
$
(786
)
 
$
(1,664
)


All amounts reclassified from accumulated other comprehensive income were related to gains (losses) on available-for-sale securities. These reclassifications impacted "Interest and other income (expense)" on the Consolidated Statements of Operations.


9. Income Taxes

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The effective tax rates for the three months ended June 30, 2013 and 2012 were 37% and 42%, respectively. The effective tax rates for the six months ended June 30, 2013 and 2012 were 32% and 56%, respectively. These rates differed from the federal statutory rate primarily due to the Federal and California R&D tax credits partially offset by state taxes and nondeductible expenses. The decrease in the Company's effective tax rate for the three and six months ended June 30, 2013 as compared to the three and six months ended June 30, 2012 was primarily due to the retroactive reinstatement of the 2012 Federal R&D credit in January 2013.

On January 2, 2013, the American Taxpayer Relief Act of 2012 (H.R. 8) was signed into law which retroactively extended the Federal R&D credit from January 1, 2012 through December 31, 2013. As a result, the Company recognized the retroactive benefit of the 2012 Federal R&D credit of approximately $3.1 million as a discrete item in the first quarter of 2013, the period in which the legislation was enacted.
As of December 31, 2012, the Company had $43.3 million of gross unrecognized tax benefits. During the six months ended June 30, 2013, the Company had an increase in gross unrecognized tax benefits of approximately $11.6 million. The gross unrecognized tax benefits, if recognized by the Company, will result in a reduction of approximately $46.1 million to the provision for income taxes thereby favorably impacting the Company’s effective tax rate. The Company’s unrecognized tax benefits are classified as “Other non-current liabilities” on the Consolidated Balance Sheets. The Company includes interest and penalties related to unrecognized tax benefits within the "Provision for income taxes" on the Consolidated Statements of Operations. As of June 30, 2013, the total amount of gross interest and penalties accrued was $3.5 million, and is classified as “Other non-current liabilities” on the Consolidated Balance Sheets.
Deferred tax assets include $11.6 million and $11.0 million classified as “Other current assets” and $66.5 million and $56.9 million classified as “Other non-current assets” on the Consolidated Balance Sheets as of June 30, 2013 and December 31, 2012, respectively. In evaluating its ability to realize the net deferred tax assets, the Company considered all available positive and negative evidence, including its past operating results and the forecast of future market growth, forecasted earnings, future taxable income, and prudent and feasible tax planning strategies. As of June 30, 2013 and December 31, 2012, it was considered more likely than not that substantially all deferred tax assets would be realized, and no significant valuation allowance was recorded.
Income tax benefits attributable to the exercise of employee stock options of $20.2 million and $0.3 million, during the three months ended June 30, 2013 and 2012, respectively, were recorded directly to "Additional paid-in capital" on the Consolidated Balance Sheets. Income tax benefits attributable to the exercise of employee stock options of $31.5 million and $4.1 million, during the six months ended June 30, 2013 and 2012, respectively, were recorded directly to "Additional paid-in capital" on the Consolidated Balance Sheets.
The Company files U.S. federal, state and foreign tax returns. The Company is currently under examination by the IRS for the years 2008 through 2011.  The Company is also currently under examination by the state of California for the years 2006 and 2007. The years 1997 through 2005, as well as 2008 through 2011, remain subject to examination by the state of California.
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.


10. Commitments and Contingencies

Streaming Content
The Company had $6.4 billion and $5.6 billion of obligations at June 30, 2013 and December 31, 2012, respectively, including agreements to license streaming content that represent current or long-term liabilities or that are not reflected on the Consolidated Balance Sheets because they do not meet the content library asset recognition criteria. The license agreements that are not reflected on the Consolidated Balance Sheets do not meet the content library asset recognition criteria because either the fee is not known or reasonably determinable for a specific title or it is known but the title is not yet available for streaming to members.
For those agreements with variable terms, the Company does not estimate the total obligation beyond any minimum quantities and/or pricing as of the reporting date. For those agreements that include renewal provisions that are solely at the option of the content provider, the Company includes the commitments associated with the renewal period to the extent such commitments are fixed or a minimum amount is specified.
The Company has entered into certain license agreements that include an unspecified or a maximum number of titles that the Company may or may not receive in the future and/or that include pricing contingent upon certain variables, such as theatrical exhibition receipts for the title. As of the reporting date, it is unknown whether the Company will receive access to these titles or what the ultimate price per title will be. Accordingly, such amounts are not reflected in the commitments described below. However such amounts are expected to be significant and the expected timing of payments could range from less than one year to more than five years.
The expected timing of payments for these agreements to acquire and license streaming content that represent current or long-term liabilities as well as obligations not reflected on the Consolidated Balance Sheets is as follows:
 

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Table of Contents

 
As of 
 
June 30,
2013
 
December 31,
2012
 
(in thousands)
Less than one year
$
2,533,061

 
$
2,299,562

Due after one year and through 3 years
2,864,331

 
2,715,294

Due after 3 years and through 5 years
830,536

 
540,346

Due after 5 years
140,177

 
78,483

Total streaming content obligations
$
6,368,105

 
$
5,633,685



The Company has licenses with certain performing rights organizations (“PROs”), and is currently involved in negotiations with other PROs, that hold certain rights to music "publicly performed" in connection with streaming content into various territories. The Company accrues for estimated royalties that are expected to be due to PROs and adjusts these accruals based on any changes in estimates. These amounts are included in Current content liabilities on the Company's Consolidated Balance Sheets. If the Company is unable to reach mutually acceptable terms with the PROs, it could become involved in litigation and /or could be enjoined from delivering certain musical compositions, which could adversely impact the Company. Additionally, pending and ongoing litigation between certain PROs and other third parties in various territories could impact the Company's negotiations with PROs. The results of these negotiations are uncertain and may be materially different from management’s estimates.
Legal Proceedings
From time to time, in the normal course of its operations, the Company is a party 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. Lead plaintiffs filed a consolidated complaint which alleged violations of the federal securities laws on June 26, 2012. 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 first amended consolidated complaint alleges violations of the federal securities laws and seeks unspecified compensatory damages and other relief on behalf of a class of purchasers of the Company's common stock between October 20, 2010 and October 24, 2011. The first amended consolidated complaint alleges, among other things, that the Company issued materially false and misleading statements primarily regarding the Company's streaming business which led to artificially inflated stock prices. The Company filed a motion to dismiss the first amended consolidated complaint on April 24, 2013; that motion is fully briefed and pending. 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 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 litigation on February 4, 2013 and on June 21, 2013, the Court granted the motion to stay the litigation. 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.

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Table of Contents

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.

11. Segment Information
The Company has three operating segments: Domestic streaming, International streaming and Domestic DVD. Segment information is presented along the same lines that the Company’s chief operating decision maker reviews the operating results in assessing performance and allocating resources. The Company’s chief operating decision maker reviews revenues and contribution profit (loss) for each of the reportable segments. Contribution profit (loss) is defined as revenues less cost of revenues and direct marketing expenses.
The Domestic and International streaming segments derive revenues from monthly membership services consisting solely of streaming content. The Domestic DVD segment derives revenues from monthly membership services consisting solely of DVD-by-mail. Revenues and the related credit card fees are attributed to the operating segment based on the nature of the underlying membership (DVD or streaming) and the geographic region from which the membership originates. There are no internal revenue transactions between the Company’s reporting 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. Marketing expenses are primarily comprised of advertising expenses which are generally included in the segment in which the expenditures are directly incurred.
As of June 30, 2013, the Company had $3.9 million in long-lived tangible assets located internationally and $124.0 million in long-lived tangible assets located in the United States. As of December 31, 2012, the Company had $4.0 million in long-lived tangible assets located internationally and $127.7 million in long-lived tangible assets located in the United States.
The following tables represent segment information for the quarter ended June 30, 2013:
 
 
As of/ Three months ended June 30, 2013
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total members at end of period (1)
29,807

 
7,747

 
7,508

 

Revenues
$
671,089

 
$
165,902

 
$
232,381

 
$
1,069,372

Cost of revenues
449,473

 
182,885

 
121,167

 
753,525

Marketing
70,302

 
48,850

 
2,608

 
121,760

Contribution profit (loss)
$
151,314

 
$
(65,833
)
 
$
108,606

 
$
194,087

Other operating expenses
 
 
 
 
 
 
136,970

Operating income
 
 
 
 
 
 
57,117

Other income (expense)
 
 
 
 
 
 
(10,468
)
Provision for income taxes
 
 
 
 
 
 
17,178

Net income
 
 
 
 
 
 
$
29,471


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Table of Contents

 
Three months ended June 30, 2013
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Amortization of content library
$
344,441

 
$
165,809

 
$
17,709

 
$
527,959

 
As of/ Six months ended June 30, 2013
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total members at end of period (1)
29,807

 
7,747

 
7,508

 

Revenues
$
1,309,738

 
$
307,921

 
$
475,674

 
$
2,093,333

Cost of revenues
885,979

 
347,909

 
246,500

 
1,480,388

Marketing
141,095

 
102,765

 
7,075

 
250,935

Contribution profit (loss)
$
282,664

 
$
(142,753
)
 
$
222,099

 
$
362,010

Other operating expenses
 
 
 
 
 
 
273,071

Operating income
 
 
 
 
 
 
88,939

Other income (expense)
 
 
 
 
 
 
(41,360
)
Provision for income taxes
 
 
 
 
 
 
15,419

Net income
 
 
 
 
 
 
$
32,160

 
Six months ended June 30, 2013
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Amortization of content library
$
680,189

 
$
315,801

 
$
35,946

 
$
1,031,936

 
As of June 30, 2013
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total content library, net
$
2,413,819

 
$
606,841

 
$
25,151

 
$
3,045,811


The following tables represent the Company’s segment information for the quarter ended June 30, 2012:
 
As of/ Three months ended June 30, 2012
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total members at end of period (1)
23,938

 
3,624

 
9,240

 

Revenues
$
532,705

 
$
64,973

 
$
291,485

 
$
889,163

Cost of revenues
378,574

 
108,542

 
156,312

 
643,428

Marketing
66,732

 
45,858

 
1,374

 
113,964

Contribution profit (loss)
$
87,399

 
$
(89,427
)
 
$
133,799

 
$
131,771

Other operating expenses
 
 
 
 
 
 
115,617

Operating income
 
 
 
 
 
 
16,154

Other income (expense)
 
 
 
 
 
 
(5,499
)
Provision for income taxes
 
 
 
 
 
 
4,491

Net income
 
 
 
 
 
 
$
6,164



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Table of Contents

 
Three months ended June 30, 2012
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Amortization of content library
$
275,495

 
$
100,502

 
$
16,304

 
$
392,301

 
As of/ Six months ended June 30, 2012
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total members at end of period (1)
23,938

 
3,624

 
9,240

 

Revenues
$
1,039,370

 
$
108,398

 
$
611,186

 
$
1,758,954

Cost of revenues
739,350

 
199,953

 
328,058

 
1,267,361

Marketing
140,137

 
100,555

 
3,200

 
243,892

Contribution profit (loss)
$
159,883

 
$
(192,110
)
 
$
279,928

 
$
247,701

Other operating expenses
 
 
 
 
 
 
233,482

Operating income
 
 
 
 
 
 
14,219

Other income (expense)
 
 
 
 
 
 
(10,589
)
Provision for income taxes
 
 
 
 
 
 
2,050

Net income
 
 
 
 
 
 
$
1,580

 
Six months ended June 30, 2012
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Amortization of content library
$
530,020

 
$
185,713

 
$
36,350

 
$
752,083

The following table represents the Company’s segment information as of December 31, 2012:
 
As of December 31, 2012
 
Domestic
Streaming
 
International
Streaming
 
Domestic
DVD
 
Consolidated
 
(in thousands)
Total content library, net
$
2,317,070

 
$
527,235

 
$
29,865

 
$
2,874,170



(1)
A membership (also referred to as a subscription) is defined as the right to receive either the Netflix streaming service or Netflix DVD service. In connection with these services, the Company offers free-trial memberships to new and certain rejoining members.  For inclusion in the definition of a member in the above metrics, a method of payment is required to be provided even during the free-trial period. Total members therefore include those who are on a free-trial and have provided a method of payment. A membership would be canceled and cease to be reflected in the above metrics as of the effective cancellation date. Voluntary cancellations become effective at the end of the monthly membership period, while involuntary cancellation of the service, as a result of a failed method of payment, becomes effective immediately.

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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 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, contribution profit (losses) and margins both domestically and internationally, DVD and streaming member trends, launch of our streaming service in the Netherlands, cash use in connection with content acquisitions and international expansion, investments in content, including expanding investments in Original content, content payments and expense, free and operating cash flow and available funds, deferred tax assets, accessing and obtaining additional capital and future contractual obligations. These forward-looking statements are subject to risks and uncertainties that could cause actual results and events to differ materially from those included in forward-looking statements. These forward-looking statements can be identified by our use of words such as "anticipate", "expect", "will", "may" and derivations thereof. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in our Annual Report on Form 10-K for the year ended December 31, 2012 filed with the Securities and Exchange Commission (“SEC”) on February 1, 2013, 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.
We will disclose material non-public information through one or more of the following channels: Netflix’s investor relations website (http://ir.netflix.com), the social media channels identified on Netflix’s investor relations website, press releases, SEC filings, public conference calls and webcasts.


Overview
We are the world’s leading Internet television network with nearly 38 million streaming members in over 40 countries enjoying more than one billion hours of TV shows and movies per month, including Netflix Original content. Our members can watch as much as they want, anytime, anywhere, on nearly any Internet-connected screen. Additionally, in the United States ("U.S."), our members can receive standard definition DVDs, and their high definition successor, Blu-ray discs (collectively referred to as “DVD”), delivered quickly to their homes.
We are a pioneer in the Internet delivery of TV shows and movies, launching our streaming service in 2007. Since this launch, we have developed an ecosystem for Internet-connected devices and have licensed increasing amounts of content that enable consumers to enjoy TV shows and movies directly on their TVs, computers and mobile devices. As a result of these efforts, we have experienced growing consumer acceptance of and interest in the delivery of TV shows and movies directly over the Internet. Historically, our acquisition of new members has been seasonal with the first and fourth quarters representing our strongest net member additions and our second quarter representing the lowest net member additions in a calendar year.
Our core strategy is to grow a streaming membership business domestically and internationally. We are continuously improving the member experience, with a focus on the quality of our streaming content mix, enhancing our user interface and improving the user experience on Internet-connected devices, while staying within the parameters of our consolidated net income and operating segment contribution profit targets. As we grow our streaming segments, we have shifted spending away from the Domestic DVD segment to invest more in streaming content and marketing for our streaming services.

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

For the Domestic and International streaming segments, content licensing expenses, which includes the amortization of the streaming content library and other expenses associated with the licensing of streaming content, represent the vast majority of cost of revenues. Streaming content rights are generally specific to a geographic region and accordingly our international expansion will require us to obtain additional streaming content licenses to support new international markets. Other cost of revenues such as content delivery expenses, customer service and payment processing fees 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. Content delivery expenses therefore also include equipment costs related to our streaming content delivery network ("Open Connect") and all third-party costs associated with delivering streaming content over the Internet. Cost of revenues in the Domestic DVD segment consists primarily of content delivery, expenses related to the acquisition of content, including amortization of DVD content library and revenue sharing expenses, and other expenses associated with our DVD processing and customer service centers. Content delivery expenses for the Domestic DVD segment consist of the postage costs to mail DVDs to and from our paying members and the packaging and label costs for the mailers.

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Table of Contents


For the Domestic and International streaming segments, marketing expenses consist primarily of advertising expenses and payments made to our affiliates and consumer electronics partners. Advertising expenses include promotional activities such as television and online advertising as well as allocated costs of revenues relating to free trial periods. Payments to our affiliates and consumer electronics partners may be in the form of a fixed fee or may be a revenue sharing payment. Marketing costs as a percentage of revenues are higher for the Domestic and International streaming segments given our focus on building consumer awareness of the streaming offerings. Marketing costs are immaterial for the Domestic DVD segment.

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. We expect that the investments in content and marketing associated with the Domestic streaming segment will slow relative to revenues to allow for contribution margin expansion over time, and we have grown contribution margin sequentially over the past six quarters. 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.

Results of Operations
The following represents our consolidated performance highlights:
 
Three Months Ended
 
Change
 
June 30,
2013
 
March 31,
2013
 
June 30,
2012
 
Q2'13 vs. Q1'13
 
Q2'13 vs. Q2'12
 
(in thousands, except per share data)
 
 
 
 
Revenues
$
1,069,372

 
$
1,023,961

 
$
889,163

 
4
%
 
20
%
Operating income
57,117

 
31,822

 
16,154

 
79
%
 
254
%
Net income
29,471

 
2,689

 
6,164

 
996
%
 
378
%
Diluted earnings per share
0.49

 
0.05

 
0.11

 
880
%
 
345
%
Free cash flow (1)
12,919

 
(41,511
)
 
11,168

 
NM

 
16
%
(1)
See “Liquidity and Capital Resources” for a definition of “free cash flow” and a reconciliation of “free cash flow” to “net cash provided by operating activities.”
Consolidated revenues for the three months ended June 30, 2013 increased $180.2 million as compared to the three months ended June 30, 2012 and $45.4 million as compared to the three months ended March 31, 2013 due to growth in streaming members, both internationally and domestically. This increase in revenues, partially offset by an increase in the cost of revenues due to continued investments in streaming content available in all regions, drove an increase in operating income and net income over the prior periods. Net income for the three months ended June 30, 2013 also increased as compared to the three months ended March 31, 2013 due to the $25.1 million loss on extinguishment of debt recognized in that prior quarter.
Free cash flow for the three months ended June 30, 2013 increased $1.8 million as compared to the three months ended June 30, 2012 and increased $54.4 million as compared to the three months ended March 31, 2013 to $12.9 million. The increase in free cash flow as compared to the three months ended March 31, 2013 is due to the increase in consolidated revenue and to a decrease in cash payments for streaming content, which was still the most significant use of cash in the quarter. We expect content payments in excess of expense to continue to fluctuate over time. Content that premieres only on Netflix in a given territory ("Original Content") or that is licensed in an earlier window through an output arrangement will typically require more up-front cash payments than other licensing agreements.

Domestic Streaming Segment
Three months ended June 30, 2013 as compared to the three months ended June 30, 2012

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As of/ Three Months Ended
 
Change
 
 
June 30,
2013
 
June 30,
2012
 
Q2'13 vs. Q2'12
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
633

 
528

 
20
%
Members at end of period
 
29,807

 
23,938

 
25
%
Paid members at end of period
 
28,624

 
22,686

 
26
%
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
671,089

 
$
532,705

 
26
%
Cost of revenues
 
449,473

 
378,574

 
19
%
Marketing
 
70,302

 
66,732

 
5
%
Contribution profit
 
151,314

 
87,399

 
73
%
Contribution margin
 
23
%
 
16
%
 
 



In the Domestic streaming segment, we derive revenues from services consisting solely of streaming content offered through a membership plan priced primarily at $7.99 per month. The $138.4 million increase in our domestic streaming revenues was due to the 26% growth in the average number of paid memberships.
The $70.9 million increase in domestic streaming cost of revenues was primarily due to the $53.9 million increase in content licensing expenses. This increase was primarily attributable to continued investments in existing and new streaming content, including exclusive and Original content, available for viewing by our members as compared to the three months ended June 30, 2012. In addition, content delivery expenses increased by $8.5 million primarily due to an increase in the total number of hours viewed by members driven by the 26% growth in the average number of paid memberships. Other costs increased $8.5 million due to an increase in payment processing fees and an increase in costs associated with customer service call centers due to our growing member base.
Marketing expenses increased $3.6 million primarily due to an increase in online advertising and public relations spend for Original content, partially offset by a decrease in television and radio advertising on brand campaigns.
Our Domestic streaming segment had a contribution margin of 23% for the three months ended June 30, 2013, which increased as compared to the contribution margin of 16% for the three months ended June 30, 2012, as a result of growing memberships and revenue faster than content spending.
Six months ended June 30, 2013 as compared to the six months ended June 30, 2012
 
 
As of/ Six Months Ended
 
Change
 
 
June 30,
2013
 
June 30,
2012
 
YTD'13 vs. YTD'12
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
2,661

 
2,267

 
17
%
Members at end of period
 
29,807

 
23,938

 
25
%
Paid members at end of period
 
28,624

 
22,686

 
26
%
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
1,309,738

 
$
1,039,370

 
26
%
Cost of revenues
 
885,979

 
739,350

 
20
%
Marketing
 
141,095

 
140,137

 
1
%
Contribution profit
 
282,664

 
159,883

 
77
%
Contribution margin
 
22
%
 
15
%
 
 




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Table of Contents

The $270.4 million increase in our domestic streaming revenues was due to the 27% growth in the average number of paid memberships.
The $146.6 million increase in domestic streaming cost of revenues was primarily due to the $115.0 million increase in content licensing expenses. This increase was primarily attributable to continued investments in existing and new streaming content, including exclusive and Original content, available for viewing by our members as compared to the six months ended June 30, 2012. In addition, content delivery expenses increased by $15.4 million primarily due to an increase in the total number of hours viewed by members driven by the 27% growth in the average number of paid memberships. Other costs increased $16.2 million due to an increase in payment processing fees and an increase in costs associated with customer service call centers due to our growing member base.
Marketing expenses for the six months ended June 30, 2013 was relatively flat as compared to the six months ended June 30, 2012.
Our Domestic streaming segment had a contribution margin of 22% for the six months ended June 30, 2013, which increased as compared to the contribution margin of 15% for the six months ended June 30, 2012, as a result of growing memberships and revenue faster than content spending.
Three months ended June 30, 2013 as compared to the three months ended March 31, 2013
 
 
As of /Three Months Ended
 
Change
 
 
June 30,
2013
 
March 31,
2013
 
Q2'13 vs. Q1'13
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
633

 
2,028

 
(69
)%
Members at end of period
 
29,807

 
29,174

 
2
 %
Paid members at end of period
 
28,624

 
27,913

 
3
 %
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
671,089

 
$
638,649

 
5
 %
Cost of revenues
 
449,473

 
436,506

 
3
 %
Marketing
 
70,302

 
70,793

 
(1
)%
Contribution profit
 
151,314

 
131,350

 
15
 %
Contribution margin
 
23
%
 
21
%
 
 

The $32.4 million increase in our domestic streaming revenues was due to the 6% growth in the average number of paid memberships. Net subscription additions were seasonally low in the second quarter of 2013. We expect domestic streaming memberships to continue to grow.
The $13.0 million increase in domestic streaming cost of revenues was primarily due to the $9.5 million increase in content licensing expenses. This increase was primarily attributable to continued investments in existing and new streaming content, including exclusive and Original content, available for viewing by our members as compared to the prior quarter. In addition, content delivery expenses increased by $1.8 million primarily due to an increase in expenses related to cloud computing services as well as an increase in depreciation related to our investments in our streaming content delivery network. Other costs increased $1.7 million primarily due to an increase in payment processing fees and an increase in costs associated with customer service call centers due to our growing member base.
Marketing expenses for the three months ended June 30, 2013 was relatively flat as compared to prior quarter.
Our Domestic streaming segment had a contribution margin of 23% for the three months ended June 30, 2013, which increased as compared to the contribution margin of 21% for the three months ended March 31, 2013, as a result of growing memberships and revenue faster than content and marketing spending.

International Streaming Segment
Three months ended June 30, 2013 as compared to the three months ended June 30, 2012

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As of /Three Months Ended
 
Change
 
 
June 30,
2013
 
June 30,
2012
 
Q2'13 vs. Q2'12
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
605

 
559

 
8
 %
Members at end of period
 
7,747

 
3,624

 
114
 %
Paid members at end of period
 
7,014

 
3,024

 
132
 %
 
 
 
 
 
 
 
Contribution profit (loss):
 
 
 
 
 
 
Revenues
 
$
165,902

 
$
64,973

 
155
 %
Cost of revenues
 
182,885

 
108,542

 
68
 %
Marketing
 
48,850

 
45,858

 
7
 %
Contribution loss
 
(65,833
)
 
(89,427
)
 
(26
)%

In the International streaming segment, we derive revenues from services consisting of streaming content offered through a membership plan priced from approximately the equivalent of USD $8 to $14 per month. In September 2010, we began international operations in Canada. We expanded to Latin America in September 2011 and the U.K. and Ireland in January 2012. In October 2012, we launched our streaming service in Finland, Denmark, Sweden and Norway. We plan on launching our streaming service in the Netherlands in the third quarter of 2013.
The $100.9 million increase in our international revenues was primarily due to the 146% growth in the average number of paid international memberships. International streaming memberships account for 21% of total streaming memberships as of June 30, 2013 as compared to 13% as of June 30, 2012. We expect international streaming memberships to continue to grow.
The $74.3 million increase in international cost of revenues was primarily due to a $67.9 million increase in content licensing expenses. This increase was primarily attributable to continued investments in existing and new streaming content, including exclusive and Original content, available for viewing in our international regions and our launch in the Nordic regions in the fourth quarter of 2012. Other costs increased $6.4 million due to an increase in content delivery expenses, increased payment processing fees, and increased costs associated with our customer service call centers all driven by the 146% growth in the average number of paid memberships.
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. International marketing expenses for the three months ended June 30, 2013 increased $3.0 million as compared to the three months ended June 30, 2012 due to marketing program spending in the Nordic regions that launched in the fourth quarter of 2012 and an increase in marketing program spending on Original content.
Our International streaming segment had a contribution loss of $65.8 million for the three months ended June 30, 2013, which decreased as compared to the contribution loss of $89.4 million for the three months ended June 30, 2012, as a result of growing memberships and revenues faster than content spending.
Six months ended June 30, 2013 as compared to the six months ended June 30, 2012

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As of/ Six Months Ended
 
Change
 
 
June 30,
2013
 
June 30,
2012
 
YTD'13 vs. YTD'12
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
1,626

 
1,766

 
(8
)%
Members at end of period
 
7,747

 
3,624

 
114
 %
Paid members at end of period
 
7,014

 
3,024

 
132
 %
 
 
 
 
 
 
 
Contribution profit (loss):
 
 
 
 
 
 
Revenues
 
$
307,921

 
$
108,398

 
184
 %
Cost of revenues
 
347,909

 
199,953

 
74
 %
Marketing
 
102,765

 
100,555

 
2
 %
Contribution loss
 
(142,753
)
 
(192,110
)
 
(26
)%

The $199.5 million increase in our international revenues was primarily due to the 164% growth in the average number of paid international memberships.
The $148.0 million increase in international cost of revenues was primarily due to a $134.6 million increase in content licensing expenses. This increase was primarily attributable to continued investments in existing and new streaming content, including exclusive and Original content, available for viewing in our international regions and our launch in the Nordic regions in the fourth quarter of 2012. Other costs increased $13.4 million due to an increase in content delivery expenses, increased payment processing fees, and increased costs associated with our customer service call centers all driven by the 164% growth in the average number of paid memberships.
International marketing expenses for the six months ended June 30, 2013 increased $2.2 million as compared to the six months ended June 30, 2012 due to marketing program spending in the Nordic regions that launched in the fourth quarter of 2012 and an increase in marketing program spending on Original content, offset by a decrease in television and radio advertising on brand campaigns.
Our International streaming segment had a contribution loss of $142.8 million for the six months ended June 30, 2013, which decreased as compared to the contribution loss of $192.1 million for the six months ended June 30, 2012, as a result of growing memberships and revenues faster than content spending.
Three months ended June 30, 2013 as compared to the three months ended March 31, 2013
 
 
As of /Three Months Ended
 
Change
 
 
June 30,
2013
 
March 31,
2013
 
Q2'13 vs. Q1'13
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net additions
 
605

 
1,021

 
(41
)%
Members at end of period
 
7,747

 
7,142

 
8
 %
Paid members at end of period
 
7,014

 
6,331

 
11
 %
 
 
 
 
 
 
 
Contribution profit (loss):
 
 
 
 
 
 
Revenues
 
$
165,902

 
$
142,019

 
17
 %
Cost of revenues
 
182,885

 
165,024

 
11
 %
Marketing
 
48,850

 
53,915

 
(9
)%
Contribution loss
 
(65,833
)
 
(76,920
)
 
(14
)%
The $23.9 million increase in our international revenues was primarily due to the 19% growth in the average number of paid international memberships.

The $17.9 million increase in international cost of revenues was primarily due to a $16.7 million increase in content licensing expenses. The increase was primarily attributable to continued investments in existing and new streaming content, including exclusive and Original content, available for viewing in our international regions.

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Table of Contents

International marketing expenses decreased $5.1 million for the three months ended June 30, 2013 as compared to the three months ended March 31, 2013 due to a seasonal decrease in online advertising on brand campaigns in the second quarter of 2013, offset by an increase in marketing program spending on Original content.
Our International streaming segment does not benefit from the established member base that exists for the Domestic segments. As a result of having to build a member base from zero, investments in streaming content and marketing programs for our International segment are larger initially relative to revenues, in particular as new territories are launched. The contribution losses for our International segment have been significant due to investments in streaming content and marketing programs to drive membership growth and viewing in our international markets. International contribution losses improved $11.1 million sequentially, due to slower growth in content and marketing spending as compared to the growth in revenues. We plan to grow our international content investments in the third quarter of 2013 slightly ahead of revenues. We expect that this growth combined with the losses associated with the launch of the Netherlands will result in an increase in International contribution loss.
 
Domestic DVD Segment
Three months ended June 30, 2013 as compared to the three months ended June 30, 2012
 
 
As of/ Three Months Ended
 
Change
 
 
June 30,
2013
 
June 30,
2012
 
Q2'13 vs. Q2'12
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net losses
 
(475
)
 
(849
)
 
(44
)%
Members at end of period
 
7,508

 
9,240

 
(19
)%
Paid members at end of period
 
7,369

 
9,145

 
(19
)%
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
232,381

 
$
291,485

 
(20
)%
Cost of revenues
 
121,167

 
156,312

 
(22
)%
Marketing
 
2,608

 
1,374

 
90
 %
Contribution profit
 
108,606

 
133,799

 
(19
)%
Contribution margin
 
47
%
 
46
%
 
 

In the Domestic DVD segment, we derive revenues from our DVD-by-mail membership services. The price per plan for DVD-by-mail varies from $4.99 to $43.99 per month based on the number of DVDs that a member may have out at any given point. Customers electing access to high definition Blu-ray discs in addition to standard definition DVDs pay a surcharge ranging from $2 to $4 per month for our most popular plans.
The $59.1 million decrease in our domestic DVD revenues was due to a 20% decrease in the average number of paid memberships.
The $35.1 million decrease in domestic DVD cost of revenues was primarily due to a $17.8 million decrease in content acquisition expenses and a $13.0 million decrease in content delivery expenses resulting from a 22% decrease in the number of DVDs mailed to paying members. The decrease in shipments was driven by a decline in the number of DVD memberships and by a 2% decrease in the DVD usage per paying member.
Our Domestic DVD segment had a contribution margin of 47% for the three months ended June 30, 2013, a slight increase from a contribution margin of 46% for the three months ended June 30, 2012.
Six months ended June 30, 2013 as compared to the six months ended June 30, 2012

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As of/ Six Months Ended
 
Change
 
 
June 30,
2013
 
June 30,
2012
 
YTD'13 vs. YTD'12
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net losses
 
(716
)
 
(1,925
)
 
(63
)%
Members at end of period
 
7,508

 
9,240

 
(19
)%
Paid members at end of period
 
7,369

 
9,145

 
(19
)%
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
475,674

 
$
611,186

 
(22
)%
Cost of revenues
 
246,500

 
328,058

 
(25
)%
Marketing
 
7,075

 
3,200

 
121
 %
Contribution profit
 
222,099

 
279,928

 
(21
)%
Contribution margin
 
47
%
 
46
%
 
 


The $135.5 million decrease in our domestic DVD revenues was primarily due to a 23% decrease in the average number of paid memberships.
The $81.6 million decrease in domestic DVD cost of revenues was primarily due to a $42.9 million decrease in content acquisition expenses and a $29.5 million decrease in content delivery expenses resulting from a 23% decrease in the number of DVDs mailed to paying members. The decrease in shipments was driven by a decline in the number of DVD memberships. Other costs, primarily those associated with content processing and customer service center expenses, decreased $9.2 million primarily due to a decrease in hub operation expenses resulting from the decline in DVD shipments.
Our Domestic DVD segment had a contribution margin of 47% for the six months ended June 30, 2013, a slight increase from a contribution margin of 46% for the six months ended June 30, 2012.
Three months ended June 30, 2013 as compared to the three months ended March 31, 2013
 
 
As of /Three Months Ended
 
Change
 
 
June 30,
2013
 
March 31,
2013
 
Q2'13 vs. Q1'13
 
 
(in thousands, except percentages)
Members:
 
 
 
 
 
 
Net losses
 
(475
)
 
(241
)
 
97
 %
Members at end of period
 
7,508

 
7,983

 
(6
)%
Paid members at end of period
 
7,369

 
7,827

 
(6
)%
 
 
 
 
 
 
 
Contribution profit:
 
 
 
 
 
 
Revenues
 
$
232,381

 
$
243,293

 
(4
)%
Cost of revenues
 
121,167

 
125,333

 
(3
)%
Marketing
 
2,608

 
4,467

 
(42
)%
Contribution profit
 
108,606

 
113,493

 
(4
)%
Contribution margin
 
47
%
 
47
%
 
 

The $10.9 million decrease in our domestic DVD revenues was primarily due to a 4% decrease in the average number of paid memberships. We expect DVD memberships to continue to decline.
The $4.2 million decrease in domestic DVD cost of revenues was primarily due to a $4.5 million decrease in content delivery expenses primarily due to an 8% decrease in DVDs mailed to paying members. This decrease was partially offset by an increase in content acquisition expenses due to more DVDs obtained through revenue sharing agreements in the second quarter of 2013 as compared to prior quarter.

25

Table of Contents

Our Domestic DVD segment had a contribution margin of 47% for the three months ended June 30, 2013, and was flat as compared to the three months ended March 31, 2013. We anticipate continuing to be able to maintain the margins we see in the first half of 2013 throughout the full year.
  
Consolidated Operating Expenses

Technology and Development
Technology and development expenses consist of payroll and related costs incurred in making improvements to our service offerings, including testing, maintaining and modifying our user interface, our recommendation, merchandising and content delivery technology, as well as our telecommunications systems and infrastructures. Technology and development expenses also include costs associated with computer hardware and software.
Three months ended June 30, 2013 as compared to the three months ended June 30, 2012
 
 
Three Months Ended
 
Change
 
June 30,
2013
 
June 30,
2012
 
Q2'13 vs. Q2'12
 
(in thousands, except percentages)
Technology and development
$
93,126

 
$
81,547

 
14
%
As a percentage of revenues
9
%
 
9
%
 
 

The $11.6 million increase in technology and development expenses was primarily due to a $9.9 million increase in personnel-related costs resulting from a 9% growth in average headcount supporting continued improvements in our streaming service and our international expansion.
Six months ended June 30, 2013 as compared to the six months ended June 30, 2012
 
 
Six Months Ended
 
Change
 
June 30,
2013
 
June 30,
2012
 
YTD'13 vs. YTD'12
 
(in thousands, except percentages)
Technology and development
$
185,101

 
$
164,348

 
13
%
As a percentage of revenues
9
%
 
9
%
 
 

The $20.8 million increase in technology and development expenses was primarily due to an $18.6 million increase in personnel-related costs resulting from an 11% growth in average headcount supporting continued improvements in our streaming service and our international expansion.
Three months ended June 30, 2013 as compared to the three months ended March 31, 2013

 
Three Months Ended
 
Change
 
June 30,
2013
 
March 31,
2013
 
Q2'13 vs. Q1'13
 
(in thousands, except percentages)
Technology and development
$
93,126

 
$
91,975

 
1
%
As a percentage of revenues
9
%
 
9
%
 
 

Technology and development expenses were relatively flat.



General and Administrative
General and administrative expenses consist of payroll and related expenses for corporate personnel, as well as professional fees and other general corporate expenses. General and administrative expenses also include the gain on disposal of DVDs.

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Table of Contents


Three months ended June 30, 2013 as compared to the three months ended June 30, 2012

 
Three Months Ended
 
Change
 
June 30,
2013
 
June 30,
2012
 
Q2'13 vs. Q2'12
 
(in thousands, except percentages)
General and administrative
$
43,844

 
$
34,070

 
29
%
As a percentage of revenues
4
%
 
4
%
 
 

General and administrative expenses increased $9.8 million primarily due to a $6.1 million increase in personnel related costs resulting from a 30% increase in average headcount. In addition, costs associated with legal claims against us and other expenses related to the use of outside and professional services and taxes increased $3.0 million.
Six months ended June 30, 2013 as compared to the six months ended June 30, 2012

 
Six Months Ended
 
Change
 
June 30,
2013
 
June 30,
2012
 
YTD'13 vs. YTD'12
 
(in thousands, except percentages)
General and administrative
$
87,970

 
$
69,134

 
27
%
As a percentage of revenues
4
%
 
4
%
 
 

General and administrative expenses increased $18.8 million primarily due to a $9.7 million increase in expenses related to the use of outside and professional services, taxes and insurance. In addition, personnel related costs increased $6.6 million primarily due to a 25% increase in average headcount.
Three months ended June 30, 2013 as compared to the three months ended March 31, 2013

 
Three Months Ended
 
Change
 
June 30,
2013
 
March 31,
2013
 
Q2'13 vs. Q1'13
 
(in thousands, except percentages)
General and administrative
$
43,844

 
$
44,126

 
(1
)%
As a percentage of revenues
4
%
 
4
%
 
 

General and administrative expenses were relatively flat, primarily due to a $2.1 million increase in personnel related costs offset by a $1.7 million decrease in expenses primarily related to the use of outside and professional services, taxes and insurance.

Interest Expense
Interest expense consists primarily of the interest associated with outstanding long-term debt obligations, including the amortization of debt issuance costs, as well as interest on our lease financing obligations.

Three months ended June 30, 2013 as compared to the three months ended June 30, 2012
 
 
 
Three Months Ended
 
Change
 
 
June 30,
2013
 
June 30,
2012
 
Q2'13 vs. Q2'12
 
 
(in thousands, except percentages)
Interest expense
 
$
(7,528
)
 
$
(5,006
)
 
50
%
As a percentage of revenues
 
1
%
 
1
%
 
 


27

Table of Contents

Six months ended June 30, 2013 as compared to the six months ended June 30, 2012

 
 
Six Months Ended
 
Change
 
 
June 30,
2013
 
June 30,
2012
 
YTD'13 vs. YTD'12
 
 
(in thousands, except percentages)
Interest expense
 
$
(14,268
)
 
$
(9,980
)
 
43
%
As a percentage of revenues
 
1
%
 
1
%
 
 
 
Three months ended June 30, 2013 as compared to the three months ended March 31, 2013
 
 
 
Three Months Ended
 
Change
 
 
June 30,
2013
 
March 31,
2013
 
Q2'13 vs. Q1'13
 
 
(in thousands, except percentages)
Interest expense
 
$
(7,528
)
 
$
(6,740
)
 
12
%
As a percentage of revenues
 
1
%
 
1
%
 
 

Interest expense for the three months ended June 30, 2013 consists primarily of $6.7 million of interest accrued on our 5.375% Notes. The increase in interest expense for the three and six months ended June 30, 2013 as compared the three and six months ended June 30, 2012 is due to the higher aggregate principal of interest bearing notes outstanding, partially offset by the lower interest rate. The increase in interest expense for the three months ended June 30, 2013 as compared to the three months ended March 31, 2013 is due to the higher aggregate principal notes being outstanding for a full period.
Interest and Other Income (Expense)
Interest and other income (expense) consists primarily of interest earned on cash, cash equivalents and short-term investments and foreign exchange gains and losses on foreign currency denominated balances.
Three months ended June 30, 2013 as compared to the three months ended June 30, 2012
 
 
 
Three Months Ended
 
Change
 
 
June 30,
2013
 
June 30,
2012
 
Q2'13 vs. Q2'12
 
 
(in thousands, except percentages)
Interest and other income (expense)
 
$
(2,940
)
 
$
(493
)
 
496
%
As a percentage of revenues
 
NM

 
NM

 
 

Six months ended June 30, 2013 as compared to the six months ended June 30, 2012

 
 
Six Months Ended
 
Change
 
 
June 30,
2013
 
June 30,
2012
 
YTD'13 vs. YTD'12
 
 
(in thousands, except percentages)
Interest and other income (expense)
 
$
(1,963
)
 
$
(609
)
 
222
%
As a percentage of revenues
 
NM

 
NM

 
 

Three months ended June 30, 2013 as compared to the three months ended March 31, 2013
 

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Three Months Ended
 
Change
 
 
June 30,
2013
 
March 31,
2013
 
Q2'13 vs. Q1'13
 
 
(in thousands, except percentages)
Interest and other income (expense)
 
$
(2,940
)
 
$
977

 
(401
)%
As a percentage of revenues
 
NM

 
NM

 
 

Interest and other income (expense) decreased for the three and six months ended June 30, 2013 as compared to the three and six months ended June 30, 2012 primarily due to increased foreign exchange losses on foreign currency denominated balances. The foreign exchange losses were $4.4 million and $4.7 million for the three and six months ended June 30, 2013, respectively, as compared to foreign exchange losses of $1.5 million and $3.0 million for the three and six months ended June 30, 2012, respectively
Extinguishment of Debt
In connection with the redemption of the outstanding $200.0 million aggregate principal amount of the 8.50% Notes, we recognized a loss on extinguishment of debt of $25.1 million in the three months ended March 31, 2013, which consisted of expenses associated with the redemption, including a $19.4 million premium payment pursuant to the make-whole provision in the indenture governing the 8.50% Notes.
Provision for Income Taxes
Our effective tax rates (benefit) for the three months ended June 30, 2013, March 31, 2013 and June 30, 2012 were 37%, (189)% and 42%, respectively. Our effective tax rates for the six months ended June 30, 2013 and June 30, 2012 were 32% and 56%, respectively. These rates differed from the federal statutory rate primarily due to the Federal and California R&D tax credits partially offset by state taxes and nondeductible expenses. The decrease in the Company's effective tax rate for the three and six months ended June 30, 2013 as compared to the three and six months ended June 30, 2012 was primarily due to the retroactive reinstatement of the 2012 Federal R&D credit in January 2013. The increase in the Company's effective tax rate for the three months ended June 30, 2013 as compared to the three months ended March 31, 2013 was due to the retroactive reinstatement of the 2012 Federal R&D credit recognized as a discrete item in the first quarter of 2013.
On January 2, 2013, the American Taxpayer Relief Act of 2012 (H.R. 8) was signed into law which retroactively extended the Federal R&D credit from January 1, 2012 through December 31, 2013. As a result, we recognized the retroactive benefit of the 2012 Federal R&D credit of approximately $3.1 million as a discrete item in the first quarter of 2013, the period in which the legislation was enacted.
Liquidity and Capital Resources
Cash, cash equivalents and short-term investments were $1,080.1 million and $748.1 million at June 30, 2013 and December 31, 2012, respectively. Our primary uses of cash include the acquisition and licensing of content, content delivery expenses, marketing and payroll related expenses. We expect to continue to make significant investments to license streaming content both domestically and internationally and will continue to expand our investments in Original content. For the twelve months ended December 31, 2013, we expect total Original content cash outflows to be less than 10% of our total payments for streaming content. Original content will typically, depending upon the terms, require more up-front cash payments relative to the expense and therefore future investments could impact our liquidity and result in a use of operating cash. As we are currently using domestic profits to fund international markets, we will raise capital as needed to fund the growth of Original content.
In February 2013, we issued $500.0 million aggregate principal amount of 5.375% Senior Notes due 2021 (the "5.375% Notes"). We used approximately $224.5 million of the net proceeds to redeem our outstanding 8.50% Notes, including a $19.4 million make-whole premium and $5.1 million of accrued and unpaid interest (See Note 6 to the consolidated financial statements for further discussion of debt). Although we currently anticipate that the remaining proceeds from the 5.375% Notes, together with our available funds, will be sufficient to meet our cash needs for the foreseeable future, we may be required or choose to obtain additional financing. Our ability to obtain additional financing will depend on, among other things, our development efforts, business plans, operating performance and the condition of the capital markets at the time we seek financing. We may not be able to obtain such financing on terms acceptable to us or at all. If we raise additional funds through the issuance of equity or debt securities, those securities may have rights, preferences or privileges senior to the rights of our common stock, and our stockholders may experience dilution.
In November 2011, we issued $200.0 million of Senior Convertible Notes and raised an additional $200.0 million through a public offering of common stock. The Senior Convertible Notes consisted of $200.0 million aggregate principal amount due on December 1, 2018 and did not bear interest. In April 2013, we exercised our option to cause the conversion of the Convertible Notes into shares of our common stock. (See Note 6 to the consolidated financial statements for discussion of debt and the conversion.)

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As of June 30, 2013, $57.8 million of cash and cash equivalents were held by our foreign subsidiaries. If these funds are needed for our operations in the U.S., we would be required to accrue and pay U.S. income taxes and foreign withholding taxes on a portion of these funds when repatriated back to the U.S.
Free Cash Flow
We define free cash flow as cash provided by operating and investing activities excluding the non-operational cash flows from purchases, maturities and sales of short-term investments. We believe free cash flow is an important liquidity metric because it measures, during a given period, the amount of cash generated that is available to repay debt obligations, make investments and for certain other activities. Free cash flow is considered a non-GAAP financial measure and should not be considered in isolation of, or as a substitute for, net income, operating income, cash flow provided by operating activities, or any other measure of financial performance or liquidity presented in accordance with GAAP.
In assessing liquidity in relation to our results of operations, we compare free cash flow to net income, noting that the three major recurring differences are excess content payments over expenses, non-cash stock-based compensation expense and other working capital differences which include deferred revenue, taxes and semi-annual interest payments on outstanding debt. Our receivables from customers settle quickly and deferred revenue is a source of cash flow. For streaming content, we typically enter into multi-year licenses with various content providers that may result in an increase in content library and a corresponding increase in liabilities on the Consolidated Balance Sheets. The payment terms for these license fees may extend over the term of the license agreements, which typically range from six months to five years.
Three months ended June 30, 2013 as compared to the three months ended June 30, 2012
 
 
Three Months Ended

June 30,
2013
 
June 30,
2012
 
(in thousands)
Net cash provided by operating activities
$
33,943

 
$
19,407

Net cash used in investing activities
(127,685
)
 
(10,654
)
Net cash provided by (used in) financing activities
48,959

 
(117
)
 
 
 
 
Non-GAAP free cash flow reconciliation:
 
 
 
Net cash provided by operating activities
33,943

 
19,407

Acquisitions of DVD content library
(14,023
)
 
(8,012
)
Purchases of property and equipment
(8,088
)
 
(3,359
)
Other assets
1,087

 
3,132

Non-GAAP free cash flow
$
12,919

 
$
11,168


Cash provided by operating activities increased $14.5 million, primarily due to an increase in subscription revenues of $180.2 million or 20%. This increase was partially offset by increased payments for content acquisition and licensing other than DVD library of $121.0 million or 24% as well as increased payments associated with higher operating expenses.
Cash used in investing activities increased $117.0 million, primarily due to an increase of $104.2 million in the purchases of short-term investments, net of proceeds from sales and maturities, and $6.0 million increase in the acquisition of DVD content library as more DVDs were obtained through direct purchase than by revenue sharing arrangements in the second quarter of 2013 as compared to the same prior year period. Investing activities were further impacted by a $4.7 million increase in the purchase of property and equipment primarily due to investments in our streaming content delivery network.
Cash provided by financing activities increased $49.1 million and primarily consisted of cash flows provided by stock option exercises.
Free cash flow was $16.6 million lower than net income for the three months ended June 30, 2013 primarily due to $47.6 million of content cash payments over expense partially offset by $18.0 million of non-cash stock-based compensation expense and $13.0 million favorable other working capital differences.
Free cash flow was $5.0 million higher than net income for the three months ended June 30, 2012 primarily due to $18.5 million of non-cash stock-based compensation expense and $11.1 million favorable other working capital differences partially offset by $24.6 million of content cash payments over expense.

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Six months ended June 30, 2013 as compared to the six months ended June 30, 2012
 
 
Six Months Ended

June 30,
2013
 
June 30,
2012
 
(in thousands)
Net cash provided by operating activities
$
21,693

 
$
38,516

Net cash used in investing activities
(306,921
)
 
(146,471
)
Net cash provided by financing activities
370,541

 
3,915

 
 
 
 
Non-GAAP free cash flow reconciliation:
 
 
 
Net cash provided by operating activities
21,693

 
38,516

Acquisitions of DVD content library
(35,216
)
 
(21,540
)
Purchases of property and equipment
(20,206
)
 
(8,125
)
Other assets
5,137

 
4,466

Non-GAAP free cash flow
$
(28,592
)
 
$
13,317


Cash provided by operating activities decreased $16.8 million, primarily due to increased payments for content acquisition and licensing other than DVD library of $298.6 million or 31%, as well as increased payments associated with higher operating expenses. The increased use of cash was partially offset by a $334.4 million or 19% increase in revenues.
Cash used in investing activities increased $160.5 million, primarily due to an increase of $135.4 million in purchases of short-term investments, net of the proceeds from sales and maturities, and a $13.7 million increase in the acquisition of DVD content library. Investing activities were further impacted by a $12.1 million increase in the purchase of property and equipment primarily due to investments in our streaming content delivery network.
Cash provided by financing activities increased $366.6 million. In the first quarter of 2013, we issued $500.0 million of 5.375% Notes, with net proceeds of $490.6 million after payment of debt issuance costs. This was offset by the $219.4 million redemption of our 8.50% Senior Notes. Financing activities were further impacted by $94.2 million of increased cash flows provided by stock option exercises.
Free cash flow was $60.8 million lower than net income for the six months ended June 30, 2013 primarily due to $145.6 million of content cash payments over expense partially offset by $35.7 million non-cash stock-based compensation expense, $24.0 million favorable other working capital differences and $25.1 million loss on debt extinguishment (a financing activity).
Free cash flow was $11.7 million higher than net income for the six months ended June 30, 2012 primarily due to $37.8 million non-cash stock-based compensation expense, $13.9 million favorable other working capital differences partially offset by $40.0 million content cash payments over expense.
Three months ended June 30, 2013 as compared to the three months ended March 31, 2013
 

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Three Months Ended
 
June 30,
2013
 
March 31,
2013
 
(in thousands)
Net cash provided by (used in) operating activities
$
33,943

 
$
(12,250
)
Net cash used in investing activities
(127,685
)
 
(179,236
)
Net cash provided by financing activities
48,959

 
321,582

 
 
 
 
Non-GAAP free cash flow reconciliation:
 
 
 
Net cash used in operating activities
33,943

 
(12,250
)
Acquisitions of DVD content library
(14,023
)
 
(21,193
)
Purchases of property and equipment
(8,088
)
 
(12,118
)
Other assets
1,087

 
4,050

Non-GAAP free cash flow
$
12,919

 
$
(41,511
)
Cash provided by operating activities increased $46.2 million, primarily due to a $45.4 million or 4% increase in revenues, as well as a decrease in payments for content acquisition and licensing other than DVD library of $15.8 million or 2%. This cash inflow was partially offset by higher operating expenses.
Cash used in investing activities decreased $51.6 million primarily due to a $43.3 million decrease in the purchases, net of proceeds from sales and maturities, of short-term investments. In addition, acquisition of DVD content library decreased by $7.2 million, as more DVDs were obtained through revenue sharing agreements in the second quarter of 2013 as compared to prior quarter and the purchases of property and equipment decreased by $4.0 million due to timing of payments.
 Cash provided by financing activities decreased $272.6 million. In the first quarter of 2013, we issued $500.0 million of 5.375% Notes, with net proceeds of $490.6 million after payment of debt issuance costs. This was offset by the $219.4 million redemption of our 8.50% Senior Notes.
Free cash flow was $44.2 million lower than net income for the three months ended March 31, 2013 primarily due to $98.0 million of content cash payments over expense partially offset by $25.1 million loss on debt extinguishment (a financing activity), $17.7 million non-cash stock-based compensation expense, and $11.0 million favorable other working capital differences.

Contractual Obligations

For the purpose of this table, contractual obligations for purchases of goods or services are defined as agreements that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. The expected timing of payment of the obligations discussed below is estimated based on information available to us as of June 30, 2013. Timing of payments and actual amounts paid may be different depending on the time of receipt of goods or services or changes to agreed-upon amounts for some obligations. The following table summarizes our contractual obligations at June 30, 2013:

 
Payments due by Period
Contractual obligations (in thousands):
Total
 
Less than
1 year
 
1-3 years
 
3-5 years
 
More than
5 years
Streaming content obligations (1)
$
6,368,105

 
$
2,533,061

 
$
2,864,331

 
$
830,536

 
$
140,177

5.375% Notes (2)
715,000

 
29,115

 
53,750

 
53,750

 
578,385

Lease obligations (3)
150,871

 
25,416

 
44,728

 
31,998

 
48,729

Other purchase obligations (4)
166,122

 
92,349

 
39,281

 
34,492

 

Total
$
7,400,098


$
2,679,941

 
$
3,002,090

 
$
950,776

 
$
767,291


(1)
Streaming content obligations include agreements to acquire and license streaming content. As of June 30, 2013, such obligations were comprised of $1.3 billion included in "Current content liabilities", $1.1 billion of "Non-current content

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liabilities" on the Consolidated Balance Sheets and $4.0 billion of obligations that are not reflected on the Consolidated Balance Sheets as they do not yet meet the criteria for asset recognition.
For those agreements with variable terms, we do not estimate what the total obligation may be beyond any minimum quantities and/or pricing as of the reporting date. For those agreements that include renewal provisions that are solely at the option of the content provider, we include the commitments associated with the renewal period to the extent such commitments are fixed or a minimum amount is specified. For these reasons, the amounts presented in the table may not provide a reliable indicator of our expected future cash outflows.
We have entered into certain streaming content license agreements that include an unspecified or a maximum number of titles that we may or may not receive in the future and/or that include pricing contingent upon certain variables, such as theatrical exhibition receipts for the title. As of the reporting date, it is unknown whether we will receive access to these titles or what the ultimate price per title will be. Accordingly such amounts are not reflected in the above contractual obligations table. However, such amounts are expected to be significant and the expected timing of payments for these commitments could range from less than one year to more than five years.

(2)
Long-term debt obligations include our 5.375% Notes consisting of principal and interest payments.

(3)
Lease obligations include lease financing obligations of $13.5 million related to our current Los Gatos, California headquarters for which we are the deemed owner for accounting purposes, commitments of $74.0 million for facilities under non-cancelable operating leases with various expiration dates through 2018, and $63.4 million of future minimum lease payments related to a facilities lease agreement entered into in the fourth quarter of 2012 to expand our Los Gatos headquarters to a nearby site. The ten year lease term for this new lease will commence after the construction of the buildings is complete. 

(4)
Other purchase obligations include all other non-cancelable contractual obligations. These contracts are primarily related to streaming content delivery, DVD content acquisition, and miscellaneous open purchase orders for which we have not received the related services or goods.

As of June 30, 2013, we had gross unrecognized tax benefits of $54.9 million and an additional $3.5 million for gross interest and penalties classified as “Other non-current liabilities” on the Consolidated Balance Sheets. At this time, we are not able to make a reasonably reliable estimate of the timing of payments in individual years due to uncertainties in the timing of tax audit outcomes; therefore, such amounts are not included in the above contractual obligation table.

Off-Balance Sheet Arrangements
As part of our ongoing business, we do not engage into any transactions with unconsolidated entities, such as entities often referred to as structured finance or special purpose entities, whereby we have financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose us to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to us.

Indemnification
The information set forth under Note 10 in the notes to the consolidated financial statements under the caption “Indemnification” is incorporated herein by reference.
Critical Accounting Policies and Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reported periods. The SEC has defined a company’s critical accounting policies as the ones 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 policies and judgments addressed below. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates.

Streaming Content Accounting
We obtain content distribution rights in order to stream TV shows and movies and Original content to members’ TVs, computers and mobile devices. Streaming content is generally licensed for a fixed fee for the term of the license agreement which may have multiple windows of availability. The license agreement may or may not be recognized in the content library.

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 When the streaming license fee is known or reasonably determinable for a specific title and the specific title is first available for streaming to members, the title is recognized on the Consolidated Balance Sheets as “Current content library, net” for the portion available for streaming within one year and as “Non-current content library, net” for the remaining portion. New titles recognized in the content library are classified in the line item “Additions to streaming content library” within net cash provided by operating activities on the Consolidated Statements of Cash Flows. The streaming content library is reported at the lower of unamortized cost or estimated net realizable value. We amortize the content library on a straight-line basis over a period not to exceed each title's contractual window of availability, which typically ranges from six months to five years.
Based on the viewing trends we see with other similar television series, we are amortizing Original content on a straight-line basis over the shorter of 4 years or the license period. If a subsequent season is added, we extend the remaining amortization period by a year. We are in the early stages of Original content and continue to monitor whether the viewing pattern is higher than initially expected in the first few months to suggest that we amortize at a faster initial rate, and then to continue on a straight-line basis for the remainder of the amortization period. In terms of relative size, of the approximately $3 billion in content library we are amortizing, currently around 5% is for Originals.
The amortization of the streaming content library is classified in “Cost of revenues” on the Consolidated Statements of Operations and in the line item “Amortization of streaming content library” within net cash provided by operating activities on the Consolidated Statements of Cash Flows. Costs related to subtitles, dubbing, and closed captioning are capitalized in “Current content library, net” on the Consolidated Balance Sheets and amortized over the window of availability. Payment terms for license fees may extend over the term of the license window, which typically ranges from six months to five years. For the titles recognized in the content library, the license fees due but not paid are classified on the Consolidated Balance Sheets as "Current content liabilities” for the amounts due within one year and as “Non-current content liabilities” for the amounts due beyond one year. Changes in these liabilities are classified in the line item “Change in streaming content liabilities” within net cash provided by operating activities on the Consolidated Statements of Cash Flows. We record the streaming content library assets and their related liability on our Consolidated Balance Sheets at the gross amount of the liability. Payments for the titles not yet available for streaming are not yet recognized in the content library but in prepaid content. Minimum commitments for the titles not yet available for streaming are not yet recognized in the content library and are discussed in Note 10 to the consolidated financial statements.
When the streaming license fee is not known or reasonably determinable for a specific title, the title does not meet the criteria for asset recognition in the content library. Titles do not meet the criteria for asset recognition in the content library because the underlying license agreement does not specify the number of titles or the license fee per title or the windows of availability per title, so that the license fee is not known or reasonably determinable for a specific title. Typical payment terms for these agreements, which can range from three to five years, require us to make equal fixed payments at the beginning of each quarter of the license term. To the extent that cumulative payments exceed cumulative amortization, prepaid content is recorded on the Consolidated Balance Sheets. We amortize the license fees on a straight-line basis over the term of each license agreement. The amortization is classified in “Cost of revenues” on the Consolidated Statements of Operations and in the line item “Net income” within net cash provided by operating activities on the Consolidated Statements of Cash Flows. Changes in prepaid content are classified within net cash provided by operating activities in the line item “Prepaid content” on the Consolidated Statements of Cash Flows. Commitments for licenses that do not meet the criteria for asset recognition in the content library are included in Note 10 to the consolidated financial statements.
Streaming content licenses (including both those that are recorded in the streaming content library and those that do not meet the criteria for asset recognition) are reviewed in aggregate at the geographic region level for impairment when an event or change in circumstances indicates a change in the expected usefulness of the content. The level of geographic aggregation is determined based on the streaming content rights which are generally specific to a geographic region inclusive of several countries (such as Latin America). An impairment would be recorded as necessary to adjust the streaming content library to the lower of unamortized cost or estimated net realizable value. No material write down from unamortized cost to a lower net realizable value was recorded in any of the periods presented.
We have licenses with performing rights organizations ("PROs"), and are currently involved in negotiations with other PROs, that hold certain rights to music "publicly performed" in connection with streaming content into various territories. For the latter, we accrue for estimated royalties that are expected to be due to PROs and adjust these accruals based on any changes in estimates. These amounts are included in our streaming content obligations. If we are unable to reach mutually acceptable terms with the PROs, we could become involved in litigation and/or could be enjoined from delivering certain musical compositions, which could adversely impact us. Additionally, pending and ongoing litigation between certain PROs and other third parties in various territories could impact our negotiations with PROs. The results of these negotiations are uncertain and may be materially different from management's estimates.
Income Taxes
We record a provision for income taxes for the anticipated tax consequences of our reported results of operations 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 as well as net 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.
Although we believe our assumptions, judgments and estimates are reasonable, changes in tax laws or our interpretation of tax laws and

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the resolution of any tax audits could significantly impact the amounts provided for income taxes in our consolidated financial statements.
In evaluating our ability to recover our deferred tax assets, in full or in part, we consider all available positive and negative evidence, including our past operating results, and our forecast of future earnings, future taxable income and prudent and feasible tax planning strategies. The assumptions utilized in determining future taxable income require significant judgment and are consistent with the plans and estimates we are using to manage the underlying businesses. Actual operating results in future years could differ from our current assumptions, judgments and estimates. However, we believe that it is more likely than not that all deferred tax assets recorded on our Consolidated Balance Sheets will ultimately be realized. In the event we were to determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to earnings in the period in which we make such determination.
We did not recognize certain tax benefits from uncertain tax positions within the provision for income taxes. We may recognize a tax benefit only if it is more likely than not the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. At June 30, 2013, our estimated gross unrecognized tax benefits were $54.9 million of which $46.1 million, if recognized, would favorably impact our future earnings. Due to uncertainties in any tax audit outcome, our estimates of the ultimate settlement of our unrecognized tax positions may change and the actual tax benefits may differ significantly from the estimates. See Note 9 to the consolidated financial statements for further information regarding income taxes.
Stock-Based Compensation
Stock-based compensation expense at the grant date is based on the total number of options granted and an estimate of the fair value of the awards.
We calculate the fair value of new stock-based compensation awards under our stock option plans using a lattice-binomial model. This model requires the input of highly subjective assumptions, including price volatility of the underlying stock. Changes in the subjective input assumptions can materially affect the estimate of fair value of options granted and our results of operations could be impacted.
 
Expected Volatility:  Our computation of expected volatility is based on a blend of historical volatility of our common stock and implied volatility of tradable forward call options to purchase shares of our common stock. Our decision to incorporate implied volatility was based on our assessment that implied volatility of publicly traded options in our common stock is more reflective of market conditions and, therefore, can reasonably be expected to be a better indicator of expected volatility than historical volatility of our common stock. We include the historical volatility in our computation due to low trade volume of our tradable forward call options in certain periods thereby precluding sole reliance on implied volatility. An increase of 10% in our computation of expected volatility would increase the total stock-based compensation expense by approximately $1.0 million for the three months ended June 30, 2013.
Suboptimal Exercise Factor:  Our computation of the suboptimal exercise factor is based on historical option exercise behavior and the terms and vesting periods of the options granted and is determined for both executives and non-executives. An increase in the suboptimal exercise factor of 10% would increase the total stock-based compensation expense by approximately $0.6 million for the three months ended June 30, 2013.



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Item 3.
 Quantitative and Qualitative Disclosures About Market Risk
For financial market risks related to changes in interest rates, reference is made to Item 7A “Quantitative and Qualitative Disclosures About Market Risk” contained in Part II of our Annual Report on Form 10-K for the year ended December 31, 2012. Our exposure to market risk has not changed significantly since December 31, 2012.

Item 4.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q were effective in providing reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934, as amended, is (i) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (ii) accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Netflix have been detected.
 
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the quarter ended June 30, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



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PART II. OTHER INFORMATION
Item 1.
Legal Proceedings
The information set forth under Note 10 in the notes to the consolidated financial statements under the caption “Legal Proceedings” is incorporated herein by reference.

Item 1A.
Risk Factors
There have been no material changes from the risk factors as previously disclosed under the heading “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

Item 6.
Exhibits
(a) Exhibits:
 
ExhibitNumber
 
Exhibit Description
 
Incorporated by Reference
 
Filed
Herewith
 
 
 
 
Form
 
File No.
 
Exhibit
 
Filing Date
 
 
 
 
 
 
 
 
 
 
3.1
 
Amended and Restated Certificate of Incorporation
 
10-Q
 
000-49802
 
3.1
 
August 2, 2004
 
 
 
 
 
 
 
 
 
 
3.2
 
Amended and Restated Bylaws
 
8-K
 
000-49802
 
3.1
 
March 20, 2009
 
 
 
 
 
 
 
 
 
 
3.3
 
Certificate of Amendment to the Amended and Restated Certificate of Incorporation
 
10-Q
 
000-49802
 
3.3
 
August 2, 2004
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
3.4
 
Certificate of Designation of Rights, Preferences and Privileges of Series A Participating Preferred Stock

 
8-K
 
000-49802
 
3.1
 
November 2, 2012
 
 
 
 
 
 
 
 
 
 
4.1
 
Form of Common Stock Certificate
 
S-1/A
 
333-83878
 
4.1
 
April 16, 2002
 
 
 
 
 
 
 
 
 
 
4.2
 
Indenture, dated November 6, 2009, among Netflix, Inc., the guarantors from time to time party thereto and Wells Fargo Bank, National Association, relating to the 8.50% Senior Notes due 2017.
 
8-K
 
000-49802
 
4.1
 
November 9, 2009
 
 
 
 
 
 
 
 
 
 
4.3
 
Indenture, dated November 28, 2011, among Netflix, Inc. and Wells Fargo Bank, National Association, relating to the Zero Coupon Senior Convertible Notes due 2018.
 
8-K
 
000-49802
 
4.1
 
November 28, 2011
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
4.4
 
Registration Rights Agreement dated November 28, 2011, by and among Netflix, Inc., TCV VII, L.P., TCV VII(A), L.P. and TCV Member Fund, L.P.
 
8-K
 
000-49802
 
10.1
 
November 28, 2011
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
4.5
 
Preferred Shares Rights Agreement, dated as of November 2, 2012, by and between Netflix, Inc. and Computershare Trust Company, N.A., as rights agent

 
8-K
 
000-49802
 
10.1
 
November 2, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
4.6
 
Indenture, dated February 1, 2013, among Netflix, Inc., the guarantors from time to time party thereto and Wells Fargo Bank, National Association, relating to the 5.375% Senior Notes due 2021.
 
8-K
 
000-49802
 
4.1
 
February 1, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
10.1†
 
Form of Indemnification Agreement entered into by the registrant with each of its executive officers and directors
 
S-1/A
 
333-83878
 
10.1
 
March 20, 2002
 
 
 
 
 
 
 
 
 
 
 10.2†
 
2002 Employee Stock Purchase Plan
 
Def 14A
 
000-49802
 
A
 
April 8, 2010
 
 
 
 
 
 
 
 
 
 
10.4†
 
Amended and Restated 2002 Stock Plan
 
Def 14A
 
000-49802
 
A
 
March 31, 2006
 
 
 
 
 
 
 
 
 
 
10.6†
 
2011 Stock Plan
 
Def 14A
 
000-49802
 
A
 
April 20, 2011
 
 
 
 
 
 
 
 
 
 
10.7†
 
Amended and Restated Executive Severance and Retention Incentive Plan

 
10-K
 
000-49802
 
10.7
 
January 31, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
10.8†
 
Description of Director Equity Compensation Plan
 
8-K
 
000-49802
 
99.1
 
June 16, 2010
 
 
 
 
 
 
 
 
 
 
10.9†
 
Description of Director Equity Compensation Plan
 
8-K
 
000-49802
 
10.1
 
December 28, 2009
 
 
 
 
 
 
 
 
 
 
31.1
 
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
 
 
X
 
 
 
 
 
 
 
 
31.2
 
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
 
 
X
 
 
 
 
 
 
 
 
32.1*
 
Certifications of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
 
 
X
 
 
 
 
 
 
 
 
101
 
The following financial information from Netflix, Inc.’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2013 filed with the SEC on July 25, 2013, formatted in XBRL includes: (i) Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2013 and 2012, (ii) Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2013 and 2012 (iii) Consolidated Balance Sheets as of June 30, 2013 and December 31, 2012, (iv) Consolidated Statements of Cash Flows for the Three and Six Months Ended June 30, 2013 and 2012 and (v) the Notes to the Consolidated Financial Statements.
 
 
 
 
 
 
 
 
 
X

*
These certifications are not deemed filed by the SEC and are not to be incorporated by reference in any filing we make under the Securities Act of 1933 or the Securities Exchange Act of 1934, irrespective of any general incorporation language in any filings.
Indicates a management contract or compensatory plan.

37

Table of Contents

SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
NETFLIX, INC.
Dated: July 25, 2013
By:
/s/    REED HASTINGS
 
 
Reed Hastings
Chief Executive Officer
(Principal executive officer)
 
 
 
Dated: July 25, 2013
By:
/s/    DAVID WELLS        
 
 
David Wells
Chief Financial Officer
(Principal financial and accounting officer)


38

Table of Contents

EXHIBIT INDEX
 
ExhibitNumber
 
Exhibit Description
 
Incorporated by Reference
 
Filed
Herewith
 
 
 
 
Form
 
File No.
 
Exhibit
 
Filing Date
 
 
 
 
 
 
 
 
 
 
3.1
 
Amended and Restated Certificate of Incorporation
 
10-Q
 
000-49802
 
3.1
 
August 2, 2004
 
 
 
 
 
 
 
 
 
 
3.2
 
Amended and Restated Bylaws
 
8-K
 
000-49802
 
3.1
 
March 20, 2009
 
 
 
 
 
 
 
 
 
 
3.3
 
Certificate of Amendment to the Amended and Restated Certificate of Incorporation
 
10-Q
 
000-49802
 
3.3
 
August 2, 2004
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
3.4
 
Certificate of Designation of Rights, Preferences and Privileges of Series A Participating Preferred Stock

 
8-K
 
000-49802
 
3.1
 
November 2, 2012
 
 
 
 
 
 
 
 
 
 
4.1
 
Form of Common Stock Certificate
 
S-1/A
 
333-83878
 
4.1
 
April 16, 2002
 
 
 
 
 
 
 
 
 
 
4.2
 
Indenture, dated November 6, 2009, among Netflix, Inc., the guarantors from time to time party thereto and Wells Fargo Bank, National Association, relating to the 8.50% Senior Notes due 2017.
 
8-K
 
000-49802
 
4.1
 
November 9, 2009
 
 
 
 
 
 
 
 
 
 
4.3
 
Indenture, dated November 28, 2011, among Netflix, Inc. and Wells Fargo Bank, National Association, relating to the Zero Coupon Senior Convertible Notes due 2018.
 
8-K
 
000-49802
 
4.1
 
November 28, 2011
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
4.4
 
Registration Rights Agreement dated November 28, 2011, by and among Netflix, Inc., TCV VII, L.P., TCV VII(A), L.P. and TCV Member Fund, L.P.
 
8-K
 
000-49802
 
10.1
 
November 28, 2011
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
4.5
 
Preferred Shares Rights Agreement, dated as of November 2, 2012, by and between Netflix, Inc. and Computershare Trust Company, N.A., as rights agent

 
8-K
 
000-49802
 
10.1
 
November 2, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
4.6
 
Indenture, dated February 1, 2013, among Netflix, Inc., the guarantors from time to time party thereto and Wells Fargo Bank, National Association, relating to the 5.375% Senior Notes due 2021.
 
8-K
 
000-49802
 
4.1
 
February 1, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
10.1†
 
Form of Indemnification Agreement entered into by the registrant with each of its executive officers and directors
 
S-1/A
 
333-83878
 
10.1
 
March 20, 2002
 
 
 
 
 
 
 
 
 
 
10.2†
 
2002 Employee Stock Purchase Plan
 
Def 14A
 
000-49802
 
A
 
April 8, 2010
 
 
 
 
 
 
 
 
 
 
10.4†
 
Amended and Restated 2002 Stock Plan
 
Def 14A
 
000-49802
 
A
 
March 31, 2006
 
 
 
 
 
 
 
 
 
 
10.6†
 
2011 Stock Plan
 
Def 14A
 
000-49802
 
A
 
April 20, 2011
 
 
 
 
 
 
 
 
 
 
10.7†
 
Amended and Restated Executive Severance and Retention Incentive Plan

 
10-K
 
000-49802
 
10.7
 
January 31, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
10.8†
 
Description of Director Equity Compensation Plan
 
8-K
 
000-49802
 
99.1
 
June 16, 2010
 
 
 
 
 
 
 
 
 
 
10.9†
 
Description of Director Equity Compensation Plan
 
8-K
 
000-49802
 
10.1
 
December 28, 2009
 
 
 
 
 
 
 
 
 
 
31.1
 
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
 
 
X
 
 
 
 
 
 
 
 
31.2
 
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
 
 
X
 
 
 
 
 
 
 
 
32.1*
 
Certifications of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
 
 
X
 
 
 
 
 
 
 
 
101
 
The following financial information from Netflix, Inc.’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2013 filed with the SEC on July 25, 2013, formatted in XBRL includes: (i) Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2013 and 2012, (ii) Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2013 and 2012 (iii) Consolidated Balance Sheets as of June 30, 2013 and December 31, 2012, (iv) Consolidated Statements of Cash Flows for the Three and Six Months Ended June 30, 2013 and 2012 and (v) the Notes to the Consolidated Financial Statements.
 
 
 
 
 
 
 
 
 
X


 


*
These certifications are not deemed filed by the SEC and are not to be incorporated by reference in any filing we make under the Securities Act of 1933 or the Securities Exchange Act of 1934, irrespective of any general incorporation language in any filings.
Indicates a management contract or compensatory plan.

39