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NETFLIX INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) 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; investments in content, including original content; international expansion and investments related thereto; cash use in connection with content acquisitions and international expansion; deferred tax assets; future pricing changes; 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, 2013 filed with the Securities and Exchange Commission ("SEC") on February 3, 2014, in particular the risk factors discussed under the heading "Risk Factors" in Part I, Item IA. We assume no obligation to revise or publicly release any revision to any forward-looking statements contained in this Quarterly Report on Form 10-Q, unless required by law. Investors and others should note that we announce material financial information to our investors using our investor relations website (http://ir.netflix.com), SEC filings, press releases, public conference calls and webcasts. We use these channels, as well as social media, to communicate with our members and the public about our company, our services and other issues. It is possible that the information we post on social media could be deemed to be material information. Therefore, we encourage investors, the media, and others interested in our company to review the information we post on the United States ("U.S.") social media channels listed on our investor relations website. Overview We are the world's leading Internet television network with more than 48 million streaming members in over 40 countries enjoying more than two billion hours of TV shows and movies per month, including original series. Our members can watch as much as they want, anytime, anywhere, on nearly any Internet-connected screen. Members can play, pause and resume watching, all without commercials or commitments. Additionally, in the U.S., our members can receive DVDs delivered quickly to their homes. We are a pioneer in the Internet delivery of TV shows and movies, launching our streaming service in 2007. Since this launch, we have developed an ecosystem for Internet-connected devices and have licensed increasing amounts of content that enable consumers to enjoy TV shows and movies directly on their TVs, computers and mobile devices. As a result of these efforts, we have experienced growing consumer acceptance of and interest in the delivery of TV shows and movies directly over the Internet. Historically, our acquisition of new members has been seasonal with the first and fourth quarters representing our strongest net member additions and our second quarter representing the lowest net member additions in a calendar year. Our core strategy is to grow our streaming subscription business domestically and internationally. We are continuously improving our members' experience - expanding our streaming content, with a focus on programming an overall mix of content that delights our customers, enhancing our user interface and extending our streaming service to even more Internet-connected devices while staying within the parameters of our consolidated net income and operating segment contribution profit (loss) targets. Our current view is to increase the monthly membership fee for our streaming plans by one to two dollars, depending on the country, in the second quarter of 2014 for new members only. Existing members would stay at current pricing for a generous time period. We believe these changes will enable us to acquire more content and deliver an even better streaming experience. Results of Operations The following represents our consolidated performance highlights: Three Months Ended Change March 31, March 31, 2014 2013 Q1'14 vs. Q1'13 (in thousands) Revenues $ 1,270,089 $ 1,023,961 24 % Operating income 97,595 31,822 207 % Net income 53,115 2,689 1,875 % Free cashflow (1) 8,406 (41,511 ) 120 % (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." 18-------------------------------------------------------------------------------- Table of Contents Consolidated revenues for the three months ended March 31, 2014 increased $246.1 million as compared to the three months ended March 31, 2013 due to growth in streaming members, both internationally and domestically. Operating income and net income increased $65.8 million and $50.4 million, respectively, due to the increase in revenues, partially offset by an increase in the cost of revenues due to increased content licensing expenses relating to our existing and new streaming content. The excess of net income over free cash flow has remained flat from $44.2 million for the three months ended March 31, 2013 to $44.7 million for the three months ended March 31, 2014, primarily due to the increase in consolidated revenues offset by an increase in cash payments for streaming content. The following represents the key elements to our segment results of operations: • We define contribution profit as revenues less cost of revenues and marketing expenses. We believe this is an important measure of our operating segment performance as it represents each segment's performance before discrete global corporate costs. • For the Domestic and International streaming segments, content licensing expenses, which include the amortization of the streaming content library and other expenses associated with the licensing of streaming content, represent the vast 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. • For the Domestic and International streaming segments, marketing expenses consist primarily of advertising expenses and payments made to our affiliates and consumer electronics partners. Advertising expenses include promotional activities such as television and online advertising. Payments to our affiliates and device partners include fixed fee and /or revenue sharing payments. Marketing costs are primarily incurred by our Domestic and International streaming segments given our focus on building consumer awareness of the streaming offerings. Marketing expenses incurred by our International streaming segment have been significant and will fluctuate dependent upon the number of International territories in which our streaming service is offered and the timing of the launch of new territories. Marketing costs are immaterial for the Domestic DVD segment. • We have demonstrated our ability to grow contribution margin as evidenced by the increase in contribution margin from 12% when we first began separately reporting Domestic streaming results in the fourth quarter of 2011 to 25% in the first quarter of 2014. As a result of our focus on growing the streaming segments, contribution margins for the Domestic and International streaming segments are lower than for our Domestic DVD segment. Investments in content and marketing associated with the International streaming segment will continue to fluctuate dependent upon the number of International territories in which our streaming service is offered and the timing of the launch of new territories. • As we grow our streaming segments, we continue to shift spending away from the Domestic DVD segment to invest more in streaming content and marketing for our streaming services. 19-------------------------------------------------------------------------------- Table of Contents Domestic Streaming Segment Three months ended March 31, 2014 as compared to the three months ended March 31, 2013 As of/ Three Months Ended Change March 31, March 31, 2014 2013 Q1'14 vs. Q1'13 (in thousands, except percentages) Members: Net additions 2,254 2,028 11 % Members at end of period 35,674 29,174 22 % Paid members at end of period 34,377 27,913 23 % Contribution profit: Revenues $ 798,617 $ 638,649 25 % Cost of revenues 517,094 440,334 17 % Marketing 80,258 66,965 20 % Contribution profit 201,265 131,350 53 % Contribution margin 25 % 21 % In the Domestic streaming segment, we derive revenues from monthly membership fees for services consisting solely of streaming content offered through a membership plan. Our Domestic streaming membership plans are priced primarily at $7.99 per month. In the second quarter of 2013, we introduced membership plans priced at $11.99 per month under which members can stream content on up to four devices concurrently. New member additions and revenue related to $11.99 membership plans were not material for the three months ended March 31, 2014. The $160.0 million increase in our domestic streaming revenues was due to the 24% growth in the average number of paid memberships. The $76.8 million increase in domestic streaming cost of revenues was primarily due to the $50.3 million increase in content licensing expenses relating to our existing and new streaming content including more exclusive and original programming. In addition, content delivery expenses increased by $15.1 million and other costs, such as payment processing fees and customer service call centers, increased $11.4 million due to our growing member base. Marketing expenses increased $13.3 million primarily due to an increase in advertising partially offset by a decrease in payments to affiliates. Our Domestic streaming segment had a contribution margin of 25% for the three months ended March 31, 2014, 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 March 31, 2014 as compared to the three months ended March 31, 2013 As of /Three Months Ended Change March 31, March 31, 2014 2013 Q1'14 vs. Q1'13 (in thousands, except percentages) Members: Net additions 1,753 1,021 72 % Members at end of period 12,683 7,142 78 % Paid members at end of period 11,755 6,331 86 % Contribution profit (loss): Revenues $ 267,118 $ 142,019 88 % Cost of revenues 245,267 166,892 47 % Marketing 56,840 52,047 9 % Contribution loss (34,989 ) (76,920 ) (55 )% 20-------------------------------------------------------------------------------- Table of Contents In the International streaming segment, we derive revenues from monthly membership fees for services consisting solely of streaming content offered through a membership plan. Our International streaming membership plans are priced primarily at the equivalent of USD $7 to $14 per month. We launched our streaming service in Canada in September 2010 and have continuously expanded our services internationally with launches in Latin America in September 2011, the U.K. and Ireland in January 2012, Finland, Denmark, Sweden and Norway in October 2012 and the Netherlands in September 2013. We plan to continue to expand our services internationally and expect a substantial European expansion in the second half of 2014. The $125.1 million increase in our international revenues was primarily due to the 91% growth in the average number of paid international memberships. Average paid international streaming memberships account for 25% of total average paid streaming memberships as of March 31, 2014, as compared to 17% of total average paid streaming memberships as of March 31, 2013. The $78.4 million increase in international cost of revenues was primarily due to a $67.7 million increase in content licensing expenses relating to our existing and new streaming content, including more exclusive and original programming. Other costs increased $10.7 million primarily due to increases in our content delivery expenses, costs associated with our customer service call centers and payment processing fees, all driven by our growing member base. International marketing expenses for the three months ended March 31, 2014 increased $4.8 million as compared to the three months ended March 31, 2013 mainly due to expenses incurred in the Netherlands, which launched in the third quarter of 2013. International contribution losses improved $41.9 million for March 31, 2014 as compared to March 31, 2013, as a result of growing memberships and revenues faster than content and marketing spending. Our International streaming segment does not benefit from the established member base that exists for the Domestic segments. As a result of having to build a member base from zero, investments in streaming content and marketing programs for our International segment are larger initially relative to revenues, in particular as new territories are launched. The contribution losses for our International segment have been significant due to investments in streaming content and marketing programs to drive membership growth and viewing in our international markets. Domestic DVD Segment Three months ended March 31, 2014 as compared to the three months ended March 31, 2013 As of/ Three Months Ended Change March 31, March 31, 2014 2013 Q1'14 vs. Q1'13 (in thousands, except percentages) Members: Net losses (278 ) (241 ) 15 % Members at end of period 6,652 7,983 (17 )% Paid members at end of period 6,509 7,827 (17 )% Contribution profit: Revenues $ 204,354 $ 243,293 (16 )% Cost of revenues 106,825 129,726 (18 )% Marketing - 74 (100 )% Contribution profit 97,529 113,493 (14 )% Contribution margin 48 % 47 % In the Domestic DVD segment, we derive revenues from our DVD-by-mail membership services. The price per plan for DVD-by-mail varies from $4.99 to $43.99 per month according to the plan chosen by the member. DVD-by-mail plans differ by the number of DVDs that a member may have out at any given point. Members electing access to high definition Blu-ray discs in addition to standard definition DVDs pay a surcharge ranging from $2 to $4 per month for our most popular plans. The $38.9 million decrease in our domestic DVD revenues was due to a 16% decrease in the average number of paid memberships. The $22.9 million decrease in domestic DVD cost of revenues was primarily due to a $4.8 million decrease in content acquisition expenses and a $12.5 million decrease in content delivery expenses resulting from a 22% decrease in the number of DVDs mailed to members. The decrease in shipments was driven by a decline in the number of DVD memberships coupled with a decrease in usage by these members. Other costs, primarily those associated with content processing and customer service center expenses, decreased $5.6 million primarily due to a decrease in hub operation expenses resulting from the decline in DVD shipments. 21-------------------------------------------------------------------------------- Table of Contents Our Domestic DVD segment had a contribution margin of 48% for the three months ended March 31, 2014, and was relatively flat as compared to the three months ended March 31, 2013. 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 March 31, 2014 as compared to the three months ended March 31, 2013 Three Months Ended Change March 31, March 31, 2014 2013 Q1'14 vs. Q1'13 (in thousands, except percentages) Technology and development $ 110,310 $ 91,975 20 % As a percentage of revenues 9 % 9 % The $18.3 million increase in technology and development expenses was primarily due to a $19.4 million increase in personnel-related costs including stock-based compensation expense resulting from an 8% growth in average headcount supporting continued improvements in our streaming service and our international expansion, coupled with an increase in employee compensation and an increase in participation in our stock option plan. 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. Three months ended March 31, 2014 as compared to the three months ended March 31, 2013 Three Months Ended Change March 31, March 31, 2014 2013 Q1'14 vs. Q1'13 (in thousands, except percentages) General and administrative $ 55,900 $ 44,126 27 % As a percentage of revenues 4 % 4 % General and administrative expenses increased $11.8 million primarily due to a $13.7 million increase in personnel related costs including stock-based compensation expense resulting from a 33% increase in average headcount to support our growth, coupled with an increase in employee compensation and an increase in participation in our stock option plan. This increase was offset by a decrease in costs associated with miscellaneous expenses related to the use of outside and professional services, taxes and insurance for the three months ended March 31, 2014 as compared to the three months ended March 31, 2013. 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 March 31, 2014 as compared to the three months ended March 31, 2013 22-------------------------------------------------------------------------------- Table of Contents Three Months Ended Change March 31, March 31, 2014 2013 Q1'14 vs. Q1'13 (in thousands, except percentages) Interest expense $ (10,052 ) $ (6,740 ) 49 % As a percentage of revenues 1 % 1 % Interest expense for the three months ended March 31, 2014 consisted primarily of $9.3 million of interest accrued on our notes. The increase in interest expense for the three months ended March 31, 2014 as compared the three months ended March 31, 2013 was due to the higher aggregate principal of interest bearing notes outstanding. 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 March 31, 2014 as compared to the three months ended March 31, 2013 Three Months Ended Change March 31, March 31, 2014 2013 Q1'14 vs. Q1'13 (in thousands, except percentages) Interest and other income (expense) $ 1,401 $ 977 43 % As a percentage of revenues NM NM Interest and other income (expense) increased for the three months ended March 31, 2014 as compared to the three months ended March 31, 2013 due to an increase in interest income and a decrease in foreign exchange losses on foreign currency denominated balances. 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 (Benefit) for Income Taxes The effective tax rates (benefit) for the three months ended March 31, 2014 and 2013 were 40% and (189)%, respectively. The effective tax rate for the three months ended March 31, 2014 differed from the federal statutory rate primarily due to state taxes, foreign taxes and nondeductible expenses. The effective tax (benefit) for the three months ended March 31, 2013 differed from the federal statutory rate primarily due to a discrete benefit recorded for Federal R&D credit. 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. The increase in our effective tax rates for the three months ended March 31, 2014 as compared to the three months ended March 31, 2013 was primarily attributable to the expiration of the Federal R&D tax credit on December 31, 2013 and from the significant effective tax (benefit) resulting from the discrete benefit recorded for the retroactive benefit of the 2012 Federal R&D credit in the three months ended March 31, 2013. Liquidity and Capital Resources Cash, cash equivalents and short-term investments were $1,668.2 million and $1,200.4 million at March 31, 2014 and December 31, 2013, respectively. In February 2014, we issued $400.0 million aggregate principal amount of 5.750% Senior Notes due 2024 (the "5.750% Notes"). 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. 23-------------------------------------------------------------------------------- Table of Contents Our primary uses of cash include licensing of content, content delivery, marketing programs and payroll. We expect to continue to make significant investments to license streaming content both domestically and internationally and in 2014 expect to substantially increase our investment in original content. Original content and content that is licensed in an earlier window through an output arrangement 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. We also expect to significantly increase our investments in international expansion, including substantial expansion in Europe in the second half of 2014. Our ability to obtain any additional financing that we may choose to, or need to, obtain to finance our international expansion, our investment in original content or otherwise, 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. As of March 31, 2014, $80.6 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 the amount associated with undistributed earnings for certain foreign subsidiaries. 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 our outstanding debt. Our receivables from members 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 March 31, 2014 as compared to the three months ended March 31, 2013 Three Months Ended March 31, March 31, 2014 2013 (in thousands) Net cash provided by (used in) operating activities $ 36,359 $ (12,250 ) Net cash provided by (used in) investing activities 57,639 (179,236 ) Net cash provided by financing activities 458,186 321,582 Non-GAAP free cash flow reconciliation: Net cash provided by (used in) operating activities 36,359 (12,250 ) Acquisition of DVD content library (14,914 ) (21,193 ) Purchases of property and equipment (13,334 ) (12,118 ) Other assets 295 4,050 Non-GAAP free cash flow $ 8,406 $ (41,511 ) Cash provided by operating activities increased $48.6 million, primarily due to an increase in subscription revenues of $246.1 million or 24%. This increase was partially offset by increased payments for content acquisition and licensing other than DVD library of $132.8 million or 21% as well as increased payments associated with higher operating expenses. Cash provided by investing activities increased $236.9 million, primarily due to a decrease of $235.6 million in purchases of short-term investments, net of proceeds from sales and maturities. Cash provided by financing activities increased $136.6 million primarily due to the $393.3 million net proceeds from the issuance of the 5.750% Notes in the three months ended March 31, 2014 compared to the $490.6 million net proceeds from the issuance of the 5.375% Notes 24-------------------------------------------------------------------------------- Table of Contents less the $219.4 million redemption of our 8.50% Notes in the three months ended March 31, 2013. Cash provided by financing activities for the three months ended March 31, 2014 primarily consisted of cash flows from the issuance of the 5.750% Senior Notes. Free cash flow was $44.7 million lower than net income for the three months ended March 31, 2014 primarily due to $110.6 million of content cash payments over expense, partially offset by $25.8 million of non-cash stock-based compensation expense and $40.1 million favorable working capital differences. Free cash flow was $44.2 million lower than net income for the three months ended March 31, 2013 primarily due to $97.2 million of content cash payments over expense partially offset by $17.7 million non-cash stock-based compensation expense, $10.2 million favorable other working capital differences and $25.1 million loss on debt extinguishment (a financing activity). 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 March 31, 2014. 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 March 31, 2014: Payments due by Period Less than More than Contractual obligations (in thousands): Total 1 year 1-3 years 3-5 years 5 years Streaming content obligations (1) $ 7,123,209 $ 3,055,127 $ 3,393,761 $ 630,518 $ 43,803 Debt (2) 1,316,524 50,514 99,750 99,750 1,066,510 Lease obligations (3) 198,946 26,220 54,526 35,115 83,085 Other purchase obligations (4) 311,843 146,304 150,914 14,625 - Total $ 8,950,522 $ 3,278,165 $ 3,698,951 $ 780,008 $ 1,193,398 (1) Streaming content obligations are related to streaming content licenses. As of March 31, 2014, such obligations were comprised of $1.8 billion included in "Current content liabilities" and $1.3 billion of "Non-current content 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. A streaming content obligation is incurred at the time we sign a license agreement to obtain future titles. Once a title becomes available, a content liability is generally recorded on the Consolidated Balance Sheets. Certain agreements include the obligation to license rights for unknown future titles, the ultimate quantity and / or fees for which are not yet determinable as of the reporting date. Because the amount is not reasonably estimable, we do not include any estimated obligation for these future titles beyond the known minimum amount. However, the unknown obligations are expected to be significant and the expected timing of payments could range primarily from one year to more than five years. (2) Long-term debt obligations include our 5.375% Notes and 5.750% Notes consisting of principal and interest payments. (3) Lease obligations include lease financing obligations of $11.3 million related to our current Los Gatos, California headquarters for which we are the deemed owner for accounting purposes and commitments of $187.6 million for facilities under non-cancelable operating leases with various expiration dates through approximately 2025, including commitments of $121.2 million for facilities lease agreements which will commence after the leased buildings have been constructed. (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 March 31, 2014, we had gross unrecognized tax benefits of $73.4 million and an additional $4.1 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 25-------------------------------------------------------------------------------- Table of Contents 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 We license rights to stream TV shows, movies, and original content to members for unlimited viewing. These licenses are for a fixed fee and specify license windows that generally range from six months to five years. Payment terms may extend over the license window, or may require more up-front payments as is typically the case for original content and content that is licensed in an earlier window through an output arrangement. We capitalize the fee per title and record a corresponding liability at the gross amount of liabilities when the license period begins, the cost of the title is known and the title is accepted and available for streaming. The portion available for streaming within one year is recognized as "Current content library" and the remaining portion as "Non-current content library" on the Consolidated Balance sheets. The acquisition of streaming content licenses rights and the changes in related liabilities, are classified within cash used in operating activities on the Consolidated Statements of Cash Flows. We amortize the content library in "Cost of revenues" on a straight line or on an accelerated basis, as appropriate: • For content that does not premiere on the Netflix service (representing the vast majority of content), we amortize on a straight-line basis over the shorter of each title's contractual window of availability or estimated period of use, beginning with the month of first availability. The amortization period typically ranges from six months to five years. • For content that premieres on the Netflix service, we expect more upfront viewing due to the additional merchandising and marketing efforts for this original content available only on Netflix. Hence, we amortize on an accelerated basis over the amortization period, which is the shorter of four years or the license period, beginning with the month of first availability. If a subsequent season is added, the amortization period is extended by a year. • If the cost per title cannot be reasonably estimated, the license fee is not capitalized and costs are expensed on a straight line basis over the license period. This typically occurs when the license agreement does not specify the number of titles, the license fee per title or the windows of availability per title. The content library is stated at the lower of unamortized cost or net realizable value. Streaming content licenses (whether capitalized or not) 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). No material write down from unamortized cost to a lower net realizable value was recorded in any of the periods presented. We have entered into certain licenses with performing rights organizations ("PROs"), and are currently involved in negotiations with other PROs, that hold certain rights to music and other entertainment works "publicly performed" in connection with streaming content into various territories. Accruals for estimated license fees are recorded and then adjusted based on any changes in estimates. These amounts are included in the streaming content obligations. The results of these negotiations are uncertain and may be materially different from management's estimates. 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 26-------------------------------------------------------------------------------- Table of Contents 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 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 substantially 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 March 31, 2014, our estimated gross unrecognized tax benefits were $73.4 million of which $61.1 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 $2.0 million for the three months ended March 31, 2014. • 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 March 31, 2014. 27-------------------------------------------------------------------------------- Table of Contents |