NetFlix 2006 Annual Report Download

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2006 Annual Report

Table of contents

  • Page 1
    2006 Annual Report

  • Page 2

  • Page 3
    LETTER TO SHAREHOLDERS NETFLIX 2006 ANNUAL REPORT DEAR FELLOW SHARE HOL DERS: 2006 was a noteworthy year for Netflix. We added a record number of new subscribers, invested in the development of our Internet delivery feature, and significantly exceeded our goals for earnings. And for the second ...

  • Page 4
    ... combination of our DVD by mail and Internet delivery service will offer a breadth of title selection unmatched by stand-alone Internet-only competitors. Underlying our strategy is the understanding that the ultimate winners in Internetbased movie rental will be the companies that provide consumers...

  • Page 5
    ... TO SHAREHOLDERS NETFLIX 2006 ANNUAL REPORT CONTI NUING THE MOME N T UM IN 2007 In 2007 we will make the best online movie rental service even better by enhancing our Web site, extending the reach of our overnight delivery infrastructure, and applying new inventory management software. We will...

  • Page 6
    PERFORMANCE NETFLIX 2006 ANNUAL REPORT Subscribers (in thousands) 6,316 4,179 2,610 1,487 '03 '04 '05 '06 Revenue (in millions) $997 $682 $501 $270 '03 '04 '05 '06 Net Income (in millions) $49 $42 $22 $7 '03 '04 '05* '06 *2005 Net Income includes ...

  • Page 7
    ... of the registrant, based upon the closing sales price for the registrant's common stock, as reported in the NASDAQ Global Select Market System, was $1,242,174,295. Shares of common stock beneficially owned by each executive officer and director of the Registrant and by each person known by the...

  • Page 8
    ...Officers and Corporate Governance ...Executive Compensation ...Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters ...Certain Relationships and Related Transactions and Director Independence ...Principal Accountant Fees and Services ...43 43 43 43 43 Market...

  • Page 9
    ...churn; developments in downloading and DVD formats; revenue per average paying subscriber; and impacts relating to our pricing strategy, delivery time, volume of movie rentals and growth of the online DVD rental market, our DVD library investments, marketing expenses, and subscriber acquisition cost...

  • Page 10
    ...a free trial period. At the end of the free trial period, subscribers are automatically enrolled as paying subscribers, unless they cancel their subscription. All paying subscribers are billed monthly in advance. We stock more than 70,000 DVD titles. We have established revenue sharing relationships...

  • Page 11
    ... subscription business provide working capital benefits and significant near-term revenue visibility. Our scalable infrastructure and online interface allow us to service our large and expanding subscriber base from a network of low-cost shipping centers. • Convenience, Selection and Fast Delivery...

  • Page 12
    ... offer more than 1,000 titles through our instant-viewing feature. Our convenient, easy-to-use Web site allows subscribers to quickly select current titles, reserve upcoming releases and build an individual queue for future viewing using our proprietary personalization technology. We provide service...

  • Page 13
    ... multiple marketing channels through which we attract subscribers to our service. Online advertising is an important channel for acquiring new subscribers. We advertise our service online through paid search listings, banner ads, text on popular Web portals and other Web sites and permission based...

  • Page 14
    ... service center is open seven days a week. We utilize e-mail and phone service to communicate with subscribers. We focus on eliminating the causes of customer support calls and providing certain self-service features on our Web site, such as the ability to report and correct most shipping problems...

  • Page 15
    ... of online subscription rental, the broad and deep selection of DVD titles we offer subscribers, our ability to personalize our library to each subscriber based on the subscriber's selection history, personal ratings and the tastes and preferences of similar users through our recommendation service...

  • Page 16
    ...-K. In this Annual Report on Form 10-K, "Netflix," the "Company," "we" and the "registrant" refer to Netflix, Inc. Our investor relations Web site is located at http://ir.netflix.com. We make available, free of charge, on our investor relations Web site under "SEC Filings" our Annual Reports on Form...

  • Page 17
    ... subscription business since our inception may continue to attract direct competition from larger companies with significantly greater financial resources and national brand recognition. We could also face competition from potential new entrants into the online DVD rental or movie download markets...

  • Page 18
    ...revenues or maintain profitability. Our principal competitors include, or could include: • video rental outlets, such as Blockbuster and Movie Gallery; • online DVD subscription rental sites, such as Blockbuster Online; • pay-per-view and VOD services; • movie retail stores, such as Best Buy...

  • Page 19
    ... slow. We depend on studios to release titles on DVD for an exclusive time period following theatrical release. Our ability to attract and retain subscribers is related to our ability to offer new releases of filmed entertainment on DVDs prior to their release to other distribution channels. Except...

  • Page 20
    ...plans, there is no established limit to the number of movies that subscribers may rent. We are continually adjusting our service in ways that may impact subscriber movie usage. Such adjustments include new Web site features and merchandising practices, computer-based instant viewing of select titles...

  • Page 21
    ... our shipping centers in a timely and efficient manner, our ability to retain existing subscribers and to add new subscribers may be impaired. In addition, through our new instant-viewing feature, our subscribers will access titles on our Web site through our proprietary movie player software and...

  • Page 22
    ... delivery and fulfillment processing would increase and our costs of replacing damaged DVDs may rise materially which would depress gross margins and profitability and adversely affect free cash flow. If we are unable to effectively utilize our recommendation service, our business may suffer. Based...

  • Page 23
    ...we are required to directly purchase more titles. If the sales price of DVDs to retail consumers decreases, our ability to attract new subscribers may be adversely affected. The cost of manufacturing DVDs is substantially less than the price for which new DVDs are generally sold in the retail market...

  • Page 24
    ...and software development teams for the continued performance of our software and computer systems. In addition, through our new instant-viewing feature, our subscribers will access titles on our Web site through our proprietary movie player software and must maintain their connection to our Web site...

  • Page 25
    ... Our subscribers pay for our subscription services predominately using credit cards and debit cards and, to a lesser extent, electronic checks. Our acceptance of these payment methods requires our payment of certain fees. From time to time, these fees may increase, either as a result of rate changes...

  • Page 26
    ... things, our Web site, our recommendation service, title selection processes and marketing activities. Trademark, copyright, patent and other intellectual property rights are important to us and other companies. Our intellectual property rights extend to our technology, business processes and the...

  • Page 27
    ... down to fair value. In any given period, if we lower our previous forecast with respect to total anticipated revenue from any individual film, we would be required to accelerate amortization of related film costs. Such accelerated amortization would adversely impact our business, operating results...

  • Page 28
    ... Global Select Market, on which our common stock is listed, has also adopted comprehensive rules and regulations relating to corporate governance. These laws, rules and regulations have increased and will continue to increase the scope, complexity and cost of our corporate governance, reporting and...

  • Page 29
    ..., investors and the financial community; • announcements of developments affecting our business, systems or expansion plans by us or others; • competition, including the introduction of new competitors, their pricing strategies and services; • market volatility in general; • the level of...

  • Page 30
    ..., forecasts of our revenues, gross margin, operating expenses, number of paying subscribers, number of DVDs shipped per day and other financial and operating data may differ materially from actual results. Such discrepancies could cause a decline in the trading price of our common stock. Item 1B...

  • Page 31
    ... public offering on May 23, 2002. The following table sets forth the intraday high and low sales prices per share of our common stock for the periods indicated, as reported by the NASDAQ Global Select Market. 2005 High Low High 2006 Low First quarter ...Second quarter ...Third quarter ...Fourth...

  • Page 32
    ... information relating to the price performance of our common stock shall not be deemed "filed" with the Commission or "soliciting material" under the Securities Exchange Act of 1934 and shall not be incorporated by reference into any such filings. The following graph compares the total cumulative...

  • Page 33
    ...Data." 2002 (1) Year Ended December 31, 2003 (1) 2004 (1) 2005 (1)(2) (in thousands, except per share data) 2006 Revenues ...Cost of revenues: Subscription ...Fulfillment expenses ...Total cost of revenues ...Gross profit ...Operating expenses: Technology and development ...Marketing ...General and...

  • Page 34
    ... 70,000 movie, television and other filmed entertainment titles on DVD. We offer a variety of subscription plans, starting at $4.99 a month. There are no due dates, no late fees and no shipping fees. Subscribers select titles at our Web site aided by our proprietary recommendation service, receive...

  • Page 35
    ... payments required under revenue sharing agreements. We amortize our DVD library, less estimated salvage value, on a "sum-of-the-months" accelerated basis over its estimated useful life. The useful life of the new-release DVDs and back-catalog DVDs is estimated to be 1 year and 3 years, respectively...

  • Page 36
    ... impact on our financial position or results of operations. We use the Black-Scholes option pricing model to determine the fair value of stock options and employee stock purchase plan shares. The Black-Scholes option-pricing model requires the input of highly subjective assumptions, including the...

  • Page 37
    ...million tax benefit. As of December 31, 2006, deferred tax assets do not include the tax benefits attributable to approximately $56 million of excess tax deductions related to stock options. These benefits will only be recorded when realized on tax returns and will be credited to equity at that time...

  • Page 38
    ... subscription period. We record refunds to subscribers as a reduction of revenues. We offer a variety of subscription plans, starting at $4.99 a month, that allow subscribers to keep either fewer or more titles at the same time. Cost of Revenues: Subscription: We acquire titles for our library...

  • Page 39
    ... related expenses we incur related to testing, maintaining and modifying our Web site, our recommendation service, developing solutions for the online delivery of content to subscribers, telecommunications systems and infrastructure and other internal-use software systems. Technology and development...

  • Page 40
    ... Supplementary Data" of this Annual Report on Form 10-K. Year Ended December 31, 2004 2005 2006 Revenues ...Cost of revenues: Subscription ...Fulfillment expenses ...Total cost of revenues ...Gross profit ...Operating expenses: Technology and development ...Marketing ...General and administrative...

  • Page 41
    ...lower cost subscription plans and the price parity of our subscription plans with those offered by competitors. • Service improvements. We continued to make improvements in a number of key areas, including increasing the selection of titles as we expanded our DVD library and enhancing our Web site...

  • Page 42
    ... driven by a 60 percent increase in the number of average paying subscribers offset by a slight decline in monthly movie rentals per average paying subscriber attributed to the increased popularity of our lower priced plans. • Postage and packaging expenses increased by 48 percent. This increase...

  • Page 43
    ... in additional expenses related to our instant viewing feature. As a result, we anticipate that cost of subscription will increase as a percentage of revenue, resulting in a decline in gross margin in 2007. Operating Expenses: Technology and Development Year Ended December 31, 2004 2005 2006 (in...

  • Page 44
    ... in marketing program costs, which included direct mail, online advertising and television advertising, to attract new subscribers. As a percentage of revenues, marketing expenses increased primarily due to a greater increase in marketing expenses than revenues. Subscriber acquisition cost increased...

  • Page 45
    ...attributable to an increase in the cost of DVD sales. Interest and Other Income Year Ended December 31, 2004 2005 2006 (in thousands, except percentages) Interest and other income, net ...As a percentage of revenues ...Percentage change over prior period ... $2,592 $5,753 $15,904 0.4% 0.9% 1.6% 122...

  • Page 46
    ... and benefits related to stock based compensation. We currently anticipate that our effective tax rate will be approximately 40% in 2007. Liquidity and Capital Resources As of December 31, 2006, we had cash and cash equivalents of $400.4 million. On May 3, 2006, we issued 3.5 million shares of...

  • Page 47
    ... in net income, the increase in amortization of DVD library as a result of increased purchases of titles, increase in depreciation of property and equipment, increase in deferred revenue due to a larger subscriber base and increase in gift subscriptions and increases in accrued expenses as a result...

  • Page 48
    ... in some cases require, estimates of fair market value. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Earlier application is encouraged, provided that the reporting entity has not yet issued financial statements for that...

  • Page 49
    ...Chief Financial Officer concluded that our disclosure controls and procedures as of the end of the period covered by this annual report on Form 10-K were effective in providing reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Securities...

  • Page 50
    ... 31, 2006. Our management's assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report that is included herein. (c) Changes in Internal Control over...

  • Page 51
    ... the sections "Security Ownership of Certain Beneficial Owners and Management" and "Equity Compensation Plan Information" in our Proxy Statement for the Annual Meeting of Stockholders. Item 13. Certain Relationships and Related Transactions and Director Independence Information required by this item...

  • Page 52
    ...' Rights Agreement Office Lease between the registrant and BR3 Partners Lease between Sobrato Land Holdings and Netflix, Inc. Lease between Sobrato Interests II and Netflix, Inc. Lease between Sobrato Interest II and Netflix, Inc. dated June 26, 2006 Description of Director Equity Compensation Plan...

  • Page 53
    Exhibit Number Exhibit Description Form Incorporated by Reference File No. Exhibit Filing Date Filed Herewith 23.1 24 31.1 Consent of Independent Registered Public Accounting Firm Power of Attorney (see signature page) Certification of Chief Executive Officer Pursuant to Section 302 of the ...

  • Page 54
    NETFLIX, INC. INDEX TO FINANCIAL STATEMENTS Page Reports of Independent Registered Public Accounting Firm ...Consolidated Balance Sheets as of December 31, 2005 and 2006 ...Consolidated Statements of Operations for the Years Ended December 31, 2004, 2005 and 2006 ...Consolidated Statements of ...

  • Page 55
    ... with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Netflix, Inc.'s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring...

  • Page 56
    ...on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan...

  • Page 57
    ... rent ...Total liabilities ...Commitments and contingencies Stockholders' equity: Common stock, $0.001 par value; 160,000,000 shares authorized at December 31, 2005 and 2006, respectively; 54,755,731 and 68,612,463 issued and outstanding at December 31, 2005 and 2006, respectively ...Additional paid...

  • Page 58
    ... (in thousands, except per share data) Year Ended December 31, 2004 2005 2006 Revenues ...Cost of revenues: Subscription ...Fulfillment expenses* ...Total cost of revenues ...Gross profit ...Operating expenses: Technology and development* ...Marketing* ...General and administrative* ...Gain...

  • Page 59
    ... of common stock under employee stock purchase plan ...378,361 Issuance of common stock upon exercise of warrants ...8,599,359 Issuance of common stock, net of costs ...3,500,000 Stock-based compensation expense ...- Stock option income tax benefits ...- Balances as of December 31, 2006 ...68,612...

  • Page 60
    ... of DVD library ...Proceeds from sale of DVDs ...Proceeds from disposal of property and equipment ...Deposits and other assets ...Net cash used in investing activities ...Cash flows from financing activities: Proceeds from issuance of common stock ...Excess tax benefits from stock-based compensation...

  • Page 61
    ... 70,000 movie, television and other filmed entertainment titles on DVD. The Company offers a variety of subscription plans starting at $4.99. There are no due dates, no late fees and no shipping fees. Subscribers select titles at the Company's Web site aided by its proprietary recommendation service...

  • Page 62
    ...fair value of the Company's cash and cash equivalents, accounts payable and accrued expenses approximates their carrying value due to their short maturity. Foreign Currency Translation and Transactions In the third quarter of 2004, the Company prepared to launch its online movie subscription service...

  • Page 63
    ... vs. Netflix, Inc. lawsuit. Amortization of DVD Library The Company amortizes its DVD library, less estimated salvage value, on a "sum-of-the-months" accelerated basis over its estimated useful life. The useful life of the new-release DVDs and back-catalog DVDs is estimated to be 1 year and 3 years...

  • Page 64
    ... related costs incurred in testing, maintaining and modifying the Company's Web Site, its recommendation service, developing solutions for the online delivery of content to subscribers, telecommunications systems and infrastructure and other internal-use software systems. Technology and development...

  • Page 65
    ...are as follows (rounded to the nearest thousand): 2004 Year Ended December 31, 2005 2006 Weighted-average shares outstanding-basic ...Effect of dilutive potential common shares: Warrants ...Employee stock options ...Weighted-average shares outstanding-diluted ...F-12 51,988,000 8,571,000 4,154,000...

  • Page 66
    ... price of excluded outstanding stock options was $30.71, $28.39 and $29.84 for the years ended December 31, 2004, 2005 and 2006, respectively. Stock-Based Compensation Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), Share-Based...

  • Page 67
    ... payments required under revenue sharing agreements. The Company amortizes its DVD library, less estimated salvage value, on a "sum-of-the-months" accelerated basis over its estimated useful life. The useful life of the new-release DVDs and back-catalog DVDs is estimated to be 1 year and 3 years...

  • Page 68
    ... direct purchase arrangements. Under the revenue sharing agreements, the Company shares a percentage of the actual net revenues generated by the use of each particular title with the studios over a fixed period of time, or the Title Term, which typically ranges from six to twelve months for each DVD...

  • Page 69
    ...equipment purchases not yet in service and approximately $3,276 of leasehold improvements associated with the leasing of the building adjacent to the Company's headquarters in Los Gatos, California. The building is expected to be completed in the first quarter of 2008, at which time the Company will...

  • Page 70
    ...outstanding as of December 31, 2006. 6. Commitments and Contingencies Lease Commitments The Company leases facilities under non-cancelable operating leases with various expiration dates through 2013. The facilities generally require the Company to pay property taxes, insurance and maintenance costs...

  • Page 71
    ... regarding DVD delivery times. The Company entered into an amended settlement under which Netflix subscribers who were enrolled in a paid membership before January 15, 2005 and were a member on October 19, 2005 are eligible to receive a free one-month upgrade in service level and Netflix subscribers...

  • Page 72
    ...) (in thousands, except share and per share data and percentages) Company's subscribers have paid artificially inflated subscription prices because potential competitors were allegedly deterred from entering the online DVD rental market by the Company's patents. The complaint purports to be on...

  • Page 73
    ...• such other amount as the Company's Board of Directors may determine. Under the 2002 Employee Stock Purchase Plan, shares of the Company's common stock may be purchased over an offering period with a duration of 24 months at 85 percent of the lower of the fair market value on the first day of the...

  • Page 74
    ...and percentages) A summary of the activities related to the Company's options is as follows: Weighted-Average Options Outstanding Remaining Aggregate Shares Available Number of Weighted-Average Contractual Term Intrinsic Value for Grant Shares Exercise Price (in Years) (in Thousands) Balances as of...

  • Page 75
    ...-Scholes option pricing model. The following table summarizes the weighted-average assumptions used to value option grants: 2004 Stock Options 2005 2006 Employee Stock Purchase Plan 2004 2005 2006 Dividend yield ...Expected volatility ...Risk-free interest rate ...Expected life (in years) ... 0% 78...

  • Page 76
    .... Total unrecognized compensation cost related to shares granted under the employee stock purchase plan as of December 31, 2006 is $515 which is expected to be recognized over the next eleven months. The following table summarizes stock-based compensation expense, net of tax, related to stock option...

  • Page 77
    ... the expected realization of its deferred tax assets. As of December 31, 2004, the Company's deferred tax assets were offset in full by a valuation allowance because of its history of losses, limited profitable quarters to date and the competitive landscape of online DVD rentals. As a result of the...

  • Page 78
    ...Internal Revenue Service. The Company matches employee contributions at the discretion of the Board of Directors. During 2004, 2005 and 2006, the Company's matching contributions totaled $379, $905 and $1,401, respectively. 11. Selected Quarterly Financial Data (Unaudited) March 31 (1) Quarter Ended...

  • Page 79
    ... attorneys-in-fact and agents, or any of them or their or his substitute or substituted, may lawfully do or cause to be done by virtue thereof. Pursuant to the requirements of the Securities and Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on...

  • Page 80
    ...' Rights Agreement Office Lease between the registrant and BR3 Partners Lease between Sobrato Land Holdings and Netflix, Inc. Lease between Sobrato Interests II and Netflix, Inc. Lease between Sobrato Interest II and Netflix, Inc. dated June 26, 2006 Description of Director Equity Compensation Plan...

  • Page 81
    Exhibit Number Exhibit Description Form Incorporated by Reference File No. Exhibit Filing Date Filed Herewith 31.2 Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Certifications of Chief Executive Officer and Chief Financial Officer Pursuant ...

  • Page 82
    ...-year period ended December 31, 2006, management's assessment of the effectiveness of internal control over financial reporting as of December 31, 2006, and the effectiveness of internal control over financial reporting as of December 31, 2006, which reports appear in this December 31, 2006 annual...

  • Page 83
    ...registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process...

  • Page 84
    ...registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process...

  • Page 85
    ... the Annual Report on Form 10-K of Netflix, Inc. for the year ended December 31, 2006 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such report fairly presents, in all material respects, the financial condition...

  • Page 86
    ... Director, Redpoint Ventures Jay Hoag2,3 General Partner, Technology Crossover Ventures Michael N. Schuh1 Managing Member, Foundation Capital Greg Stanger1 Venture Partner, Technology Crossover Ventures 1 2 3 CORPORATE HEADQUARTERS Netï¬,ix, Inc. 100 Winchester Circle Los Gatos, CA 95032 Phone...

  • Page 87
    Netflix, Inc. • 100 Winchester Circle • Los Gatos, CA 95032 • www.netflix.com