Letter to shareholders, July 18, 2016:
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.
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 ungrandfather 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 ungrandfathered 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 ungrandfathering and associated media coverage may moderate nearterm membership growth, we believe that ungrandfathering will provide us with more revenue to invest in our content to satisfy members, thus driving longterm growth. Over the second half of this year, we’ll complete ungrandfathering. Our threetier 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 underforecast 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 lowerthanexpected 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 ungrandfathering 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.
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 ungrandfathering 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. Ungrandfathering occurred in Canada, UK/Ireland, Latin America, and the Nordics during Q2 where, like the US, we saw a similar, earlierthanexpected impact on retention. In our newer markets, we continue to learn and believe that growth will unfold over a multiyear 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 20102013 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 longterm 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).
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 6090 million members. We continue to expect to run around breakeven 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.
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 mostwatched 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 Englishlanguage 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 nonEnglish 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 20152016 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. Next year, Netflix will also be the exclusive home of the new Star Trek series from CBS outside the US and Canada, with new episodes arriving in 188 countries within 24 hours of their North American premiere.
We primarily market our originals to drive member acquisition. Building off that, this past quarter we began testing the availability of select episodes of a few of our original shows on linear television in partnership with broadcasters. One week after its premiere on Netflix, the first two episodes of our first French original series, Marseille, aired on French broadcast network TF1. Season one episodes (but not season two) of Narcos and Club de Cuervos will air on Univision and Unimas, respectively, in the US. Through these tactics, we’re aiming to entice consumers to join Netflix to complete their binge. The danger is diluting the perception that Netflix original content is only on Netflix, so we are testing cautiously.
Product and Partnerships
As we have noted in the past, our global expansion in January means that we are now operating in some markets where consumers access the Internet primarily through mobile devices. This has led us to invest more in our mobile experience including sign up, authentication, user interface, payments and streaming efficiency for cellular networks. In Q2, we began testing Google Play inapp payment on Android devices, which we think will aid our ability to acquire new customers in many international markets, as our iOS inapp payments have done.
To date, we have partnered with over 40 MVPDs across the world to make it easier for consumers to enjoy and pay for Netflix, to grow awareness of our service in certain markets and to reach different demographic segments. In the US, we are excited that Netflix will be available on the Comcast X1 settop box later this year.
Strong Net Neutrality
We continue to make progress with Open Connect, and the approval of the Charter/TWC merger with a seven year condition of settlementfree interconnect is a helpful precedent. When ISPs around the world agree to take our Open Connect servers in or near their networks for free, they see reductions in their network costs, and as a result, the program has continued to grow in popularity.
Our goal remains to win as many “moments of truth” as we can. Given all the leisure activities consumers can engage in reading a book, playing videogames, watching a sports match, etc. we compete with a very broad set of alternatives. Our focus is to improve Netflix every day across multiple dimensions including content, streaming quality, device footprint, payment options, and more. If we can do that, we believe we have ample room to grow.
There are an increasing number of virtual MVPDs, like Sony Vue, DISH’s Sling TV, Amazon’s Streaming Partners Program, and Hulu’s forthcoming service, which offer a smaller bundle of TV channels at a lower cost per month. To the degree these services provide an improved MVPD experience or spur improvement amongst incumbent MVPDs to become more Internetcentric (ondemand, multiscreen, personalized), they will become increased competition for entertainment time.
In the most recent Sandvine report, our share of North American Internet traffic was 35%. As we referenced in our Q4 ’15 letter in January, our implementation of more efficient encoding would reduce our results in the Sandvine report, which measures peak megabits, not peak viewing hours.
Free Cash Flow and Capital Structure
In Q2’16, free cash flow amounted to $254 million, compared with $261 million in Q1’16. We finished the quarter with cash and equivalents of $1.8 billion, while gross debt was unchanged at $2.4 billion. We still plan to raise additional capital through the high yield market later in 2016/early 2017.
Our capital requirements continue to be driven by our investment in original content, particularly programming that we produce, which requires more cash upfront relative to licensed content.
Original content provides Netflix with many benefits: new programming that debuts on Netflix, exclusivity, greater creative and business control, global rights and brand halo. These merits outweigh the timing of cash payments.
Our choice to fund these requirements through debt rather than equity is based on our desire to optimize our capital structure to yield the lowest possible weighted average cost of capital. Given our low debt to total capital ratio, the after tax cost of debt is currently more attractive than equity.
We finished Q2’16 with 4.5 million DVD members in the US, and contribution profit of $71 million.
For quick reference, our eight most recent investor letters are: April 2016, January, 2016, October 2015, July 2015, April 2015, January 2015, October 2014, July 2014.
While we did not grow as fast as forecast in Q2, we are optimistic about the future owing to our singular focus, global scale and the growth of Internet TV viewing. We are in the very early days of the shift from linear television to ondemand viewing and there are nearly 1 billion pay TV subscribers worldwide who will migrate to Internet TV over the coming decades.
On a personal note, this week we release season three of Bojack Horseman since you all follow the media business, this is a series you may love as much as we do.