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| Tuesday, Jan 19, 2016
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With earnings of 10 cents per share in the fourth quarter ending Dec. 31,, Netflix beat Wall Street expectations of 2 cents and added more net subscribers (5.56 million versus expectations of 5.1 million) as it continued its major push into international markets.

Tuesday’s Netflix letter to shareholders follows.

 

netflixOn January 1st, just a few hours after the quarter closed, we crossed 75 million members. Our quarter-end 74.76 million members put us at over 17 million net additions for the year, showing how much the world is embracing Internet TV. We think we’ll grow by over 6 million members in Q1 given our expansion of Netflix to virtually everywhere but China. We bring great stories from all over the world to people all over the world.

 

Q4 Results and Q1 Forecast

In the fourth quarter, we added a record 5.59 million members as our big shows such as Narcos and Marvel’s Jessica Jones helped us grow membership to 74.76 million. This 5.59 million compares to a forecast of 5.15 million and to prior year net additions of 4.33 million. For Q1, we are forecasting 6.10 million net additions vs. prior year of 4.88 million. On earnings, we stayed profitable in Q4 despite foreign exchange headwinds, and delivered operating income of $60m and net income of $43m. We expect similar modest operating income results for Q1, assuming current foreign exchange, as we invest in our international expansion. As a reminder, the guidance we provide is our actual internal forecast at the time we report, and we strive for accuracy in our guidance.

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In September, we launched in Japan, followed by Spain, Portugal and Italy in October. We are very pleased with the first few months of membership growth in these markets. Our international contribution loss of $109 million in Q4 increased sequentially due to these launches. We anticipate Q1 international losses of about $114 million.

In early January at CES, we announced the availability of Netflix everywhere in the world except China. Pricing is comparable to our existing plans and we have added support for Korean, Arabic, and Simplified & Traditional Chinese languages. Our move into 130 additional countries broadens our addressable market by 190 million broadband homes, on top of the 360 million we counted at the end of 20151.

While the opportunity is large, our growth in these new markets will unfold over many years as we improve our service. We are starting by primarily targeting outward-looking, affluent consumers with international credit cards and smartphones. As with every market we’ve launched, our approach is to listen, learn and improve rapidly, adding more content, additional languages and a better Netflix experience over time. Our global availability sets us up for continued growth for many years and we continue to expect material global profits beginning in 2017.

In Q4, average subscriber price grew 4-5% y/y around the world, excluding the impact of foreign currency (-$106 million y/y impact on revenue). In the US it was 4.3%, leading to 21% year over year growth in streaming revenue. We are seeing increased adoption of our Ultra-HD plan ($11.99) as more UHD TVs are purchased and as we are a leading source of UHD content for consumers.

In the US, we ended 2015 with nearly 45 million members, although our Q4 US net adds were down year over year, as expected (1.56m actual versus 1.90m prior year). Our high penetration in the US seems to be making net additions harder than in the past. Our forecast for Q1 US net additions is 1.75m, against a prior year actual of 2.28m. New credit/debit card rollover continues to be a background issue. In Q2 and Q3, we’ll be releasing a substantial number of our US members from price grandfathering on the HD plan and they will have the option of continuing at $7.99 but now on the SD plan, or continuing on HD at $9.99 a month. Given these members have been with us at least 2 years, we expect only slightly elevated churn. Our 2020 US contribution target remains at 40% and we are already at 34%.

In the last remaining major market, China, we have work and uncertainty ahead. We are building relationships, understanding the market, and seeking the conditions we require to provide our service to entertainment lovers there. Our expectations are modest and long-term. We may be able to get started this year and thus deliver on “whole world by end of 2016” or it may take longer. Most of our focus is on the 130 countries we launched on January 6, which are now embracing Netflix as a new entertainment option.

 

Content

In Q4 ‘15, we launched an unprecedented number of original series and films, while maintaining a high bar on quality. We unveiled five new original series in Q4, including Marvel’s Jessica Jones and Master of None, starring Aziz Ansari. Both combined with Narcos, Sense8, Marvel’s Daredevil and Bloodline to claim six of the Top 10 new TV shows of 2015 according to IMDB. In late December, we debuted a ten-part documentary series Making a Murderer, which has enthralled audiences and critics alike and triggered a national conversation on fairness of the American criminal justice system.

Our first original feature films also premiered in Q4. Beasts of No Nation, a gripping journey into the world of African child soldiers from writer and director Cary Fukunaga and starring Idris Elba, was a favorite of critics and has picked up several major awards nominations. Adam Sandler’s first Netflix original film The Ridiculous Six, which debuted globally on December 11, was the most viewed movie on Netflix in every territory the week of its debut and the most-viewed movie ever on Netflix in the first 30 days on service. Two of our original documentaries, What Happened, Miss Simone- and Winter on Fire, are both nominated for Academy Awards, our third and fourth nominations in three years for best documentary feature.

In 2016, we plan to launch over 600 hours of original programming, up from about 450 hours in 2015. Beyond the sheer volume of content, the breadth of our original programming will continue to expand with current plans for new seasons of 30 or so original series (including The Crown and The Get Down), eight original feature films, 35 new seasons of original series for kids, a dozen documentaries, and nine stand up comedy specials.

We are now in our fourth year of original programming and we are putting special emphasis on shows that families can enjoy together, including the upcoming Fuller House, new seasons of Unbreakable Kimmy Schmidt, and Stranger Things. We are also stepping up our non-English language original productions, including Marseille, a French political drama starring Gerard Depardieu, and then, shows from Italy, Japan, Mexico and Brazil. We expect some of these series to gain fans well beyond the markets in which they were made.

Increasingly, our goal is to own more of our original programming to allow for greater creative and business control and to ensure global access to content. We are currently actively managing productions spanning the globe from Cambodia to Venice Beach.

The growth of Netflix has created some anxiety among TV networks and calls to be fearful. Or, at the other extreme, an NBC executive recently said Internet TV is overblown and that linear TV is “TV like God intended.” Our investors are not as sure of God’s intentions for TV, and instead think that Internet TV is a fundamentally better entertainment experience that will gain share for many years. The challenge for traditional media companies, most of whom see the future pretty clearly, is to use the revenue from Netflix and other SVOD services to fund both great content and their own evolution into Internet TV networks. Seeso, BBC iPlayer, Hulu, CanalPlay, HBO Now, and CBS All Access are the beginnings of these efforts.

Our titles are watched on the go and at home on a wide range of devices, making measurement of the viewing of any given title difficult for third parties. We don’t release title-level ratings as our business model is not dependent on advertising or affiliate fees. Instead, we release “ratings “ for Netflix as a whole every quarter with our membership growth report (75 million and counting!). It is member viewing and satisfaction that propels our growth.

 

Product

We have been innovating in support of our global launch, focusing on adding new languages, new payment options and fine-tuning our algorithms for our growing number of content catalogs.

Additionally, this involves expanding and deepening our partnerships with device makers and mobile and TV operators to reach and serve our members around the world.

We recognize that in some parts of the world, mobile is the primary way many people access the Internet. We are improving our mobile experience, including sign up, credentials & authentication, the user interface, and streaming efficiency for cellular networks.

In Q4, we began rolling out complexity based encoding. By encoding videos based on the type of content (a visually complex action movie vs. a simpler kids animated title, for example) rather than just based on the amount of bandwidth available to a member, we can deliver higher resolution streams at lower bit rates, resulting in bandwidth savings.

We have long used a blacklist to prevent cross-border content viewing via proxies and “unblockers.” Recently, we have begun to use a new blacklist and other techniques, as are other SVOD services, as desired by content licensors. Ultimately, our goal is to let members around the world enjoy all the content we have through global licensing.

 

Marketing

Promoting high quality, exclusive titles continues to be the best driver of consumer demand for Netflix. Our recent new market launches reflect this philosophy, and our all-digital, content-led marketing approach is working. Our brand strength is rising in many studies, including a #2 ranking reported in AdWeek for the USA. Around the world, our all digital approach makes us efficient and relevant to active Internet users everywhere.

 

Competition

Our focus on “winning moments of truth” means that we compete with all of the activities that consumers can engage in during their leisure time, such as reading a book, playing videogames, watching linear TV, movie theatre-going, etc. Given the broad array of options, we are privileged that our members around the world continue to devote more time to Netflix, streaming 42.5 billion hours in 2015, up from 29 billion hours in 2014.

In addition, looking at just the online segment, the most recent Sandvine data illustrates that our share of peak North American downstream Internet traffic continues to grow. Please note that the deployment of complexity based encoding, as described above, will result in what appears to be slower growth in Netflix traffic in future third-party reports such as Sandvine (which measures peak megabits, not peak viewing hours).

As we have said previously, Internet TV will likely have multiple winners as the various services are not direct substitutes for each other given differing sets of content. A closer look at the Sandvine data shows that the entire Over-the-Top category is growing as consumers increasingly embrace Internet TV and on demand viewing and, even better, this growth is coming at the expense of piracy.

 

Free Cash Flow and Capital Structure

Free cash flow amounted to -$276 million in Q4 and -$921 million for the full year 2015. As a reminder, our investment in originals, particularly owned content, requires more cash upfront relative to licensed content, which will continue to dampen free cash flow. We finished Q4 with debt of $2.4 billion, unchanged from the prior quarter, and with cash & equivalents and short-term investments of $2.3 billion.

Given our expected cash needs, we are likely to raise additional debt in late 2016 or early 2017. We are managing our balance sheet to lower our blended cost of capital over time, while maintaining financial flexibility. Despite being FCF negative as we grow our original content and invest in international, our bonds trade like a BB credit (vs. their single B rating) due, in part, to the long-term growth of Internet TV globally and our low debt to market cap ratio, which provides bond investors with a very thick cushion of protection.

 

DVD

Our DVD-by-mail business in the US continues to serve more than 4.9 million members. We are pleased that our DVD business is managing the decline well, despite increasing postal costs, generating $80 million in contribution profit in Q4.

 

Reference

For quick reference, our eight most recent investor letters are: October 2015, July 2015, April 2015, January 2015, October 2014, July 2014, April 2014, January 2014.

 

Summary

We are thrilled to be available worldwide ex-China. What fun we are having making our service popular in Thailand, Poland, Australia, Chile, France and over 180 other countries.

 

Sincerely,

Reed Hastings, CEO

David Wells, CFO

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