July 18, 2016 Fellow Shareholders, We Grew by 1.7M Members in Q2
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July 18, 2016 Fellow shareholders, We grew by 1.7m members in Q2 finishing with over 83 million members. This is below our forecast of 2.5m net new members and our prior year Q2 net additions of 3.3m. We are growing, but not as fast as we would like or have been. Disrupting a big market can be bumpy, but the opportunity ahead is as big as ever and we continue to improve every aspect of our business. 1 Q2 Results and Q3 Forecast Our global member forecast for Q2 was 2.5m and we came in at 1.7m. Gross additions were on target, but churn ticked up slightly and unexpectedly, coincident with the press coverage in early April of our plan to un-grandfather longer tenured members and remained elevated through the quarter. We think some members perceived the news as an impending new price increase rather than the completion of two years of grandfathering. Churn of members who were actually un-grandfathered is modest and conforms to our expectations. With our large subscriber base, slight variances in retention versus forecast can result in significant swings in net adds, particularly in a seasonally small net add quarter like Q2. While un-grandfathering and associated media coverage may moderate near-term membership growth, we believe that un-grandfathering will provide us with more revenue to invest in our content to satisfy members, thus driving long-term growth. Over the second half of this year, we’ll complete un-grandfathering. Our three-tier pricing (in the US: $7.99 SD, $9.99 HD, and $11.99 UHD) is working well for us and for new members, and our gross additions remain healthy. On earnings, we slightly under-forecast the quarter, ending Q2 with operating income of $70 million and net income of $41 million against a forecast of $47 million and $9 million with the variance largely due to lower-than-expected content and other costs. As a reminder, the quarterly guidance we provide is our actual internal forecast at the time we report and our goal is to be accurate, not conservative. Therefore, in some quarters, we may come in high versus our forecast and, in other quarters, we may come in low. In the US, our Q2 net additions were 0.16 million against a forecast of 0.50 million. US revenue rose 18% year over year with domestic ASP growing 4.5% year over year. As expected, US contribution margin at 34.3% expanded more moderately year over year, owing to the timing of content spend. In addition, marketing expenses rose sequentially in support of our growing slate of originals and business partnerships, which we expect to continue. As Internet TV rises in popularity, so do the SVOD offerings. In the US, for example, CBS All Access, Seeso, Amazon Prime Video, Hulu, YouTube Red, and many others are all growing. Our view, however, is that we are all growing primarily against linear TV hours and that competition did not contribute materially to our miss in Q2. First, increased competition would show up mostly in soft gross additions rather than churn. Second, we experienced a similar uptick in churn in early April in Canada, where there has been no recent increase in SVOD competition but where un-grandfathering is also underway. Similarly, we don’t believe market saturation is a key factor in the US given that we experienced similar performance over the same period in multiple countries with differing levels of Netflix market penetration. 2 Our global membership forecast for Q3 includes an impact from the spectacle of the Olympics, on par with what we experienced four years ago, and does not include any boost in the US from the Comcast X1 launch due to uncertainty on timing as we and Comcast will only release Netflix on the X1 when the viewer experience is great. For Q3, we forecast US net adds of 0.3 million as un-grandfathering continues. We expect US contribution margin to improve year over year in both Q3 and Q4 and we anticipate meeting our 40% US contribution margin target by 2020, or even earlier. International net additions in Q2 came to 1.5 million compared to our 2.0 million forecast. Un-grandfathering occurred in Canada, UK/Ireland, Latin America, and the Nordics during Q2 where, like the US, we saw a similar, earlier-than-expected impact on retention. In our newer markets, we continue to learn and believe that growth will unfold over a multi-year period, similar to our experience in Latin America. International revenue rose 67% year over year. Excluding the impact of F/X (-$37 million impact on a y/y basis), international ASP increased 8.7%. International contribution profit totaled -$69 million as content spending was slightly lower than our forecast. For Q3, we expect international net additions of 2.0m. Our approach in expanding our global footprint in January was to launch a service targeting early adopters and then to listen, learn and iterate quickly. Now that we are six months in, we will localize Netflix in Poland and Turkey with the addition of local language in the user interface, subtitles and dubbing. Localization in other markets will take place over time as economically prudent. International contribution loss in Q3 is expected to be -$95 million as improving profitability in our earlier foreign markets funds the investment in newer international territories. We remain confident in these investments because of our success in all of the markets launched prior to 2014 which are individually profitable on a contribution profit basis. These 2010-2013 launch markets are on track to deliver aggregate contribution profit of around $500 million in 2016. Prior to the global launch of our service in January, Netflix was available in 60 countries. In these earlier expansion markets, our adoption rate in the first several months (as measured by penetration of broadband households) has been highly varied and the initial uptake is not necessarily indicative of our long-term penetration. We have already achieved success (contribution profits) in many types of markets including those where English is not the main language (e.g. Chile); that have low pay TV penetration (e.g. Australia); that have historically had high levels of piracy (e.g. Nordics); that have payment or broadband infrastructure challenges (e.g. Mexico with payments and Canada with low data caps); that have big competition (e.g. UK); that have low disposable income (e.g. Brazil); or that have many of these factors (e.g. most of Latin America). 3 Unfortunately, this year the regulatory climate in China for our service has become more challenging. Disney’s streaming service, launched in conjunction with Alibaba, was closed down, as was Apple’s movie offering. We continue to explore options and, in the meantime, have plenty of work to do in our newly opened markets. Our global expansion is an exciting opportunity that will unfold over many years. Continued US growth will be a part of it and there is no change to our view that in the US Netflix can reach 60-90 million members. We continue to expect to run around break-even on a net income basis in 2016 and to generate material profits in 2017 and beyond. We will drive operating profit growth in 2017 by reducing our international losses and continuing to grow US profit. Content In Q2, we continued to expand the pace and breadth of original series, films and documentaries released on Netflix, including the 4th season of Orange is the New Black and the second of our Adam Sandler films, The Do Over, which, at launch, was the number one most-watched film on Netflix in every territory of the world and remains in the top 10 in many countries, including the US. The substantial viewing of our growing slate of originals around the world is a testament to how well high quality English-language TV travels. Local content constitutes a small minority of total viewing in our international segment. We do not plan on trying to outcompete local TV networks in local content in every nation of the world. Rather, we selectively complement our service with licensed and original local content. We are developing non-English language original series and films in more than a dozen countries including Brazil, Germany, India, Italy, Japan, Mexico, Colombia, South Korea, Argentina and Spain when we find compelling, high quality projects with attractive economics and a potentially large audience around the world. Narcos, only partially in English, is an early success in this area. We are also pleased with the critical acclaim received by our original programming. Last week, 17 of our original series, documentaries, films and comedy specials received 54 Primetime Emmy nominations, up from 34 last year. Netflix saw the largest increase in nominations among networks and has the third most total nominations of any domestic network (behind only FX and HBO). Earlier, nine of our kids’ shows received 33 Daytime Emmy nominations, more than any other network. We have made good progress since launching our first original series Lilyhammer in 2012. While ramping up originals, we are also actively acquiring high quality, licensed content. We’ve extended our licensing agreement with The CW Network, making Netflix the US SVOD home for prior seasons of all scripted series broadcast on The CW beginning with the 2015-2016 TV season. Netflix members will be able to stream full seasons of programs like Legends of Tomorrow, Supergirl, Arrow and The Flash, just eight days after each season finale.