NetFlix 2005 Annual Report Download - page 29

If we are unable to effectively utilize our recommendation service, our business may suffer.
Based on proprietary algorithms, our recommendation service enables us to predict and recommend titles
and effectively merchandize our library to our subscribers. We believe that in order for our recommendation
service to function most effectively, it must access a large database of user ratings. We cannot assure you that the
proprietary algorithms in our recommendation service will continue to function effectively to predict and
recommend titles that our subscribers will enjoy, or that we will continue to be successful in enticing subscribers
to rate enough titles for our database to effectively predict and recommend new or existing titles.
We are continually refining our recommendation service in an effort to improve its predictive accuracy and
usefulness to our subscribers. We may experience difficulties in implementing such refinements. In addition, we
cannot assure you that we will be able to continue to make and implement meaningful refinements to our
recommendation service.
If our recommendation service does not enable us to predict and recommend titles that our subscribers will
enjoy or if we are unable to implement meaningful improvements, our personal movie recommendation service
will be less useful, in which event:
• our subscriber satisfaction may decrease, subscribers may perceive our service to be of lower value and
our ability to attract and retain subscribers may be affected adversely;
• our ability to effectively merchandise and utilize our library will be affected adversely; and
• our subscribers may default to choosing titles from among new releases or other titles that cost us more
to provide, and our margins may be affected adversely.
If we do not correctly anticipate our short and long-term needs for titles, our subscriber satisfaction and
results of operations may be affected adversely.
If we do not acquire sufficient copies of titles, we may not satisfy subscriber demand, and our subscriber
satisfaction and results of operations could be affected adversely. Conversely, if we attempt to mitigate this risk
and acquire more copies than needed to satisfy our subscriber demand, our inventory utilization would become
less effective and our gross margins would be affected adversely.
If we are unable to renew or renegotiate our revenue sharing agreements when they expire on terms
favorable to us, or if the cost of purchasing titles on a wholesale basis increases, our gross margins may be
affected adversely.
Since 2000, we have entered into numerous revenue sharing arrangements with studios and distributors.
These revenue sharing agreements generally have terms of up to five years. Revenue share agreements typically
enable us to increase our copy depth of DVDs on an economical basis because of the low initial payment.
Additional payments are made only if our subscribers rent the DVD. Under a purchase arrangement, we must pay
the full wholesale price, regardless of whether the DVD is rented. In addition, revenue sharing agreements
generally provide for studio promotional support of the associated DVD and our service as well as permit us to
own the DVD following expiration of the revenue sharing period, typically no more than 12 months following
street date.
During the course of our revenue sharing relationship with studios and distributors, various contract
administration issues arise. To the extent that we are unable to resolve any of these issues in an amicable manner,
our relationship with the studios and distributors may be adversely impacted.
As our revenue sharing agreements expire, we may be required to negotiate new terms that could be
disadvantageous to us or if we cannot renew the agreements we would be required to purchase titles. In such
event, the cost of acquiring content could increase and our gross margins may be affected adversely. In addition,
if we were required to purchase titles the risk associated with accurately predicting title demand could increase.
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