EXHIBI T
A
Net Net, Flix By Mail Has Arrive d
• Business . Netflix sells DVD rental-bv-mail
subscriptions . facilitated by online title selection
and an efficient inventory management system .
e' S EPS tero6orma Dl)uted )
=-FY Eud: Dec EPS P!E
2000
(33 99)
n .m .
(2 .341
2001
2002
2003E
2004E
n .m .
(0.04)
• Estimates . We believe Netflix can double its
free cash flow in 2003 . Our proforma EPS
projection is SO . 18 in FY03 and 50 .50 in FY04 .
n. in .
0 .18
0 .50
88 . '
32 .7
- .~ Revenges S ull]_
!
=-F1~ ESnd `Der ev ? Rev MuI
35 .9
75 .9
152 .8
249 .7
337 .9
2000
2001
2002
2003E
2004E
10 . 1
4.8
2.4
1 4
1.1
Price . Date 314/03
S16 .2 5
52-Week Ranee
$4 .85 - $22 .3 3
Norm . 3-Yr . EPS Growth
40%
Market Cap (S mil .)
361 . 1
Diluted Shares (mil.)
Fl oat (mil .)
22 . 2
18 . 9
• D rivers . Continued growth of DVD hardware
sales and DVD software rentals is the primary
driver, as well as Netflix's ability to offer oneday delivery to a majority of customers .
• Limite rs. Increased competition from Walmart .com and Blockbuster, as well as any major
change in studio revenue-sharing terms, could
slow growth .
• Conclusion . Our valuation discounts five years'
adjusted free cash flow at a 20% cost of capital
and a 6x terminal multiple .
We a re initiating coverage with a BUY rating
and a 12-month price target of $20 per share .
~, . .Capttalizadon Dan z
Debt (S mil .)
0.0
103 . 6
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$4 .0 2
Equity (S mil .)
Debt/Equity
Tantdble Book ValuetShare
Cash.'Share
$4 .6 6
Daily Volume (10-day avg)
S&P 500
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Investors should assume that Roth Capital Partners. LLC
("RCP") expects to receive or intends to seek compensation
for investment banking or other business relationships with
the covered companies mentioned in this report in the next
three months.
Please refer to important disclosure information on the last page of this report .
Rich Ingrassia
949-720-716 1
ringrassia roihcp.com
NETFLI X
SUMMARY
We are initiating coverage of Netflix (Nasdaq : NFLX $16 .25) with a BUY rating an d a 12-month price target
of S20 per share .
Netflix re nts DV"Ds, but has no sto re s . Subscribers
pay a monthly fee to rent up to three DVDs at a time
for as long as they want, with no late penalties, by
selecting titles in their Netflix .com "Rental Queue" .
When a customer returns a DVD using Netflix's
postage-paid mailer, the next DVD in the queue is
automatically shipped by first-class mail and arrives as
soon as the next day .
Netflix invented this unique home video channel
and in 2002 p ro ved it could be p ro fitable . Though
the Company faces potentially strong competition from
Walmart .com and
Blockbuster ,
we believe
management directs operations well and has the right
strategy for growth.
In this report we consider all external factors (Industry
& Competitive) and internal factors (Strategy &
Operations) that spur and/or limit key drivers in
Netflix's business . We summarize them in Figure 1 on
page 3 .
Our research and assumptions on these variables
combine to produce our financial projection for Netflix
in 2003 and 2004 . We believe Netflix will generate
S0 .18 proforma EPS in FY03 . More significantly, we
believe the Company can more than double free cash
flow (FCF) this year and next .
Our price target is based on five years' discounted FCF
- adjusted for stock-based compensation - at a 20%
required rate of return . The projections summarized in
the table below are generally in line with management
guidance and slightly more optimistic than consensus
analyst estimates .
Figure 2 - Netfix Fundamentals , 2001-200 4
FY01
Rn enues
(SM)
75 .9
Total Subxnbcn
(000)
P,d Sabsaiba Growth
(•.)
456
37%
A,g . Monthly Chum
(:)
Subscriber ACquaouon Cost
(S)
.6.8%
40.29
Fulfillment Ex pense' . of R e,
P1.)
Othei Opem mg Eap erases
(SM)
Non-Cuh Compensation
(Sill)
Adjusted Free Cash Flow
ISM)
i 11 1,
D iluted EPS (GAAP)
Diluted EPS ) Profomsai '
(5)
(S)
(2 741
_,4)
FY02
FY03E
FY04 E
152.8
249.7
337.9
857
1 .322
99%
555.
.6.9'.16
1 .64 2
26•x.
b.8%
34 .11
17.7%
-6 .9%
31 .24
12 .75.
22. 4
216
29.6
37
99
13.9
01 .8
14 0
13.1
34. 6
(0 .431
0 .18
004
0 .50
6.0
it 1')
Mo0-4
In its sho rt public life, NFLX stock has seen some
dramatic swings in value . Five months after a S17per-share IPO, NFLX dropped to S5 .22, partly due to
the launch of Walmart .com's DVD-by-mail service in
September . NFLX shares recovered to the mid-teens by
2002 year-end, thanks to the Company's continued
subscriber growth in spite of the well-capitalized new
competitor .
We expect NFLX shares to remain volatile . Risks and
downside catalysts include the following :
■
If sell-through DVD pricing drops by more than S I
per year ( from about S17 today) for the next 2-3
years, or "disposable" DVDs become popular
• If the major motion picture studios materially
change their revenue - sharing terms, or decide to
alter the video window ' s primacy over PPV and
other home ente rt ainment choices
• If Blockbuster significantly reduces the cost of its
Freedom Pass subscription, or decides to better
fund its FilmCaddy .com busines s
■
If Walmart .com cuts prices further in its DVD
rental service, or another competitor such as
Amazon .com enters the rental marke t
■
If the conversion rate of free-to-paid subscribers
drops to less than 70%
• If Netflix's theft and loss rate (currently 3% of
gross shipments) increases dramaticall y
■
If mail delivery experiences a slowdown, as
happened in late 2001 due to the anthrax scare
■
If non-option related insider selling becomes more
substantial, especially by CEO Reed Hastings and
operations VP Thomas Dillon, who have sold
small blocks since Nov . 2002 .
The risks above prompted us to be conservative in our
assumptions . However, we believe Netflix has
considerable upside potential as the dominant player in
an increasingly profitable business . From current
trading levels, we point out the following metrics and
events as signs Netflix is on target to meet Wall Street
estimates and upside catalysts for the stock :
37 .2 8
12.8%
• If Company- repo rt ed chum is less than 7% in
Q1 :03 or for two consecutive quarters in FY0 3
• When Netflix announces openings of new regional
shipping center s
• Proforma EPS excludes non-cash conpensatnn and one - tine [ens .
For important disclosure in/ormation- see the end of this report .
ROTH CAPITAL PARTNERS, LLC
NETFLIX
Figure 1 - Factors That Affect Netflix Model
INDUSTRY I COMPETITIVE
FACTORS
NETFLIX STRATEGIC I OPERATING
VARIABLES FACTORS
NOLs
{ N Tres )
For important disclosure information - see the end of this report .
ROTH CAPITAL PARTNERS, LLC
NETFLI X
penetration of TV HH . We expect this to occur in
2006 .
• If Walmart .com scales back its DVD rental
busines s
Consensus industry estimates from Forrester, Kagan
World Media and others put U .S. DVD HH penetration
at close to 60M by year-end 2003 and 65M by 2004, a
32% compound annual growth rate . That compares to a
76% CAGR from 2000-2002, suggesting deceleration
has already begun .
• When CEA reports positive growth in DVD
hardware sales, typically announced each month
■
When short sellers cover their position, which is
now close to IN the average daily volume .
We are initiating coverage with a BUY rating .
DVD Rental : A Bigger S li ce of the Home V ideo Pie
DVD rentals generated S2 .9B in 2002 retail sales, up
107% from 2001, as rapid hardware growth drove the
continued shift to DVD software . Total U .S . video
rentals generated S8 .2B in 2002 retail sales, down
3 .1% from 2001, according to the Video Software
Dealers Association . That means VHS rentals were
down 25% to S5 .3B, and that DVD went from zero to
35% of the total rental market in just four years. By
year-end 2004, consensus industry research suggests
DVD will account for S5 . 5B in sales or 651/0 of the
total video market . (See Figure 4 . )
INDUSTRY & COMPETITIO N
The lightweight, inexpensively replicated DVI) is what
made Netflix's rental -by-mail concept possible . Rapid
growth of the DVD platform will continue, albeit at a
decelerated pace, driving Netflix' s addressable
customer base ever larger . Competition is expected to
heat up in the online DVD rental business , while rental
retailers like Netflix continue to balance their success
vs . formidable supplier leverage.
Figure 4 - U.S. Video Software Retail Rentals ($ mil)
Rapid Growth of DVD Platform Is Levelin g
DVD is the fastest-penetrating consumer electronics
product in history. Since its 1998 introduction, more
than 43M DVD players have been sold in the U .S .
alone, penetrating one-third of all U .S . households in
2002-not including DVD-equipped PCs . (See Figure
3. )
199e
1999
2000 r>'.= - a c-.
2001
ra ..+.
200
E203
Figure 3 - U.S DVD Households (mil)
200IE r . . an.
$0 52000 04,000 06 .000
1
S8.000
010.000
O vHs UDVD
Source: CEA, RCP estimates
Though there seems to be no doubt that DVD will
eventually be the only significant packaged-goods
video media, low DVD sell-through pricing creates
competition for the DVD rental business that did not
exist in the VHS platform for 20 years . In recent years,
aggressive pricing has driven DVD sell-through to its
status as the biggest single source (37%) of all filmed
entertainment revenues . (Source : Roth Capital Partners
estimate from Kagan World Media data.) In addition, a
number of other broadcast-based home entertainment
choices such as pay TV, pay-per-view (PPV) and
video-on-demand (VOD) now compete with the "rental
chain" model .
Source : CEA . RCP estimates
Obviously, the torrid pace of DVD growth cannot
continue forever, but it is difficult to find a proxy for
the DVD adoption cu rv e , given the product's
unprecedented
popularity with
U .S. consumers .
However, if one were to use penetration of VCR
players or basic cable as a model, it suggests adoption
will level off at 6%-7% CAGR when DVDs reach 80%
ROTH CAPITAL PARTNERS, LLC
For important disclosure information- see the end of this report
4
NETFLI X
Fortunately for Netflix - and Blockbuster and HBO
and many other entertainment retailers - new media
platforms historically have NOT led to total
cannibalization of the platform that came before . That
is, TV did not kill radio, cable TV did not kill
broadcast -I1-, and home video did not wipe out the
theatrical release . Instead, the pie just grew bigger .
We think it's likely this trend will continue . DVD
rental will always compete with sell-through, but we
believe both will grow rapidly over the next several
years . We anticipate little cannibalization from pay
channels and VOD, as has been the case for several
years, and especially since cable VOD now gravitates
more toward TV content .
IP-based movie VOD such as Movielink ( a JV between
MGM, Paramount, Sony Pictures, Universal and
Warner Bros .) also poses a threat to the packagedgoods rental model . But we expect the impact from this
channel to be negligible until TV set m anufacturers or
home networkers make streaming practical to the
family room, not just the home office .
Of course, in any assessment of home entertainment
choices the most important factor to consider is movie
revenue "windows," as set by the major studios. As
long as the top content creators continue to give posttheatrical primacy to home video over PPV, VOD and
other release windows, Netflix, Blockbuster and other
companies that peddle packaged media will be
relatively secure . Given their overwhelming reliance
on packaged video (and its higher margins) we think
it's unlikely the studios will force widespread adoption
of new movie sales channels in the near future .
Netflix Still Best of the Online Rental B re e d
Because of their extra features - director
commentaries, DVD-ROM games and the like - DVDs
are uniquely suited to Netflix' s rent-as-long-as-youwant model . However, the main benefit of an online
rental-by-mail service is in eliminating the time spent
going to/from video stores . For that reason, we do not
believe store-based subscription plans such as
Blockbuster's Freedom Pass (in its current form)
present a significant threat to Netflix .
Netflix subscribers pay $19 .95 per month to rent three
DVDs at a time, plus a use tax of up to 51 .55 per
month, all credit-card billed in advance . Different
service levels are offered (e .g . two DVDs at a time for
S13 .95) but the 3-disk program is by far the most
popular .
Each subscriber goes to Netflix .com to search and
select the titles he/she wishes to rent, often assisted by
Netflix's CineMatch rating and recommendation
function . Desired rentals are prioritized in an individual
"Rental Queue ." Customers then receive their DVDs
by first-class mail ; postage is included in the monthly
fee. The packaging doubles as a postage-paid return
mailer; when a subscriber returns a DVD, the next one
in his/her Rental Queue is shipped .
A subscriber can keep a DVD for as long as he/she
wants, and no late fee is billed . However, if a
subscriber wants to maximize the financial benefit of
the service vis-a-vis the traditional storefront service,
it's obviously in his/her interest to return DVDs
promptly . If a DVD is lost in the mail, subscribers
inform the Company via web mail and a replacement
DVD (or the next title in the Queue) is shipped .
Walmart . com the Most Se rious Competitive Th re at
Netflix owns the web-based DVD rental subscription
business, with more than 90% market share . However,
the competitive landscape became significantly more
complex in mid-2002 when Wal-Mart .com launched its
online rental -by-mail service .
We tested or took trial subscriptions to Walmart .com
and other rival online rental services, and remain
convinced of the Netflix's edge in ease of use and
functionality . (See Figure 5 .) Broad one-day fulfillment
capability is a major competitive advantage for Netflix
today, none of its peers can provide this level of
service on as wide a scale . In our opinion, Netflix is
also superior in title selection and search software . In
public comments, even Blockbuster CEO John Antioco
dubbed Netflix the likely winner vs . Walmart .com.
That being said, the convenience and omnipresence of
video rental chains such as Blockbuster and Hollywood
Video present a major challenge for Netflix . By
definition, the corner video store offers immediate
"fulfillment," and thanks to revenue sharing, most
stores offer a fairly deep selection of titles , especially
popular new releases .
For important disclosure information - see the end of th is report .
ROTH CAPITAL PARTNERS, LLC
NETFLIX
Figure 5 - Product Comparison : Online DVD Rental
result we believe the Company may occasionally be
subjected to a "supplier squeeze . "
Service
DYDs
STRATEGY & OPERATIONS
Netflit
3
S1995,month
Delive ry
Tim e
1-4 days
Wslmart . com
3
S18 .86, month
2-5 days
No shippmgilate
FilmCaddv . com
4
S19 .95 .!month
2-3 days
Qnik Fliks .com
2 to 12
DVDovernight.com
I
RentMyDVD. com
Unlimited
515 .99 to
3 .7 days
55799~mon[h
$3 - S4 per
2-4 days
DAD for 7 days
$3 .50 per DVD 2-3 days
for 9 days
No s hipping/ We
fees
No shWpmgrlac e
fees
Within 7 days - no
return shipping fee
Within 9 days S1 .50 ship pin g fe e
per d is c , $0.50 fo r
additional disc .
S3 .50'disc late fee
No ship pmg;lat e
fees
2 to 10
I Rates
S13 .95 to
549 .95/month
Return s
No shrpmg/ Late
fees
3-4 days
fees
Source: Company data and Roth Capital Partners research .
Despite its well-capitalized parentage, Walmart .com's
DVD Rentals service has yet to gain traction, as recent
estimates put subscribers at less than 25,000 . In our
opinion, the reason is almost certainly delivery time,
which reportedly averages 3 days . (The company just
opened a new DVD distribution center in Brisbane, CA
to reduce delivery time in the L .A. area.) It is also
generally believed Wal-Mart doesn't want to
cannibalize its store-based sell-through business, which
the discounter uses as a loss leader to drive traffic into
stores . Nevertheless, Wal-Mart is a formidable foe for
anyone's retail operation, and their market entry here
must be considered an ongoing threat .
Studios' Content Leverage Strong As Eve r
On one hand, Netflix's business exists today because
the Company was able to strike some of the industry's
first revenue-sharing deals with the major studios
(Disney, Fox, MGM, Universal, Sony and Warner) . In
addition to a shared stake in growing the online
subscriber base, the studios were also given preferred
convertible stock for approximately 6% of the
Company. Netflix obviously knew its Hollywood
history that many intelligent and potentially profitable
new media channels have died on the vine without
vigorous major studio support . (Divx, anyone? )
Netflix's headquarters is in Los Gatos . CA_ The
Company employed 381 people at year-end 2002 . and
morale seems very high at this dot-com survivor .
One-Day Fulfillment Is the Number-One Priority
Netflix has had tremendous success in its home market,
the San Francisco Bay Area, where 3 .810 of total
households are subscribers . That compares to less than
1% of households nationwide . Management believes
that their success in the Bay Area is mostly due to the
fact that subscribers have enjoyed one-day delivery
there since inception, a service level made possible by
the proximity of Netflix's main distribution center in
San Jose. (Oneday delivery means one day to return a
DVD and one day to deliver the next DVD in the
queue, and therefore total turnaround time of two
days . )
Consequently, Netflix opened 12 regional shipping
centers in 2002 in the following mar kets : Duluth
(Atlanta), Worcester ( Boston), Dallas , Denver, Detroit,
Houston, Santa Ana (Los Angeles), Minneapolis,
Flushing (New York), Stamford, Tacoma ( Seattle) and
Washington, D .C . The Company reported that in Dec .
2002, 36% of all subscribers were reachable in one
day .
The Comnanv plans to open an additi onal 10-1 5
shipping centers in 2003 , or about I per month . In
February 2003, Netflix opened new hubs in Newark .
Philadelphia and Phoenix . At this pace the Company
will have more than 25 regional hubs by year-end and,
management says, able to reach 70% of its subscribers
in one day .
Yet no matter how vested the content creators are in
Netflix's business, one fact remains : These distributors
control 70%-80% of U.S . film and TV programming
and therefore possess an extraordinary amount of
leverage in pricing and availability.
DVD acquisition is Netflix 's l ar gest single cost center,
and revenue-sharing agreements can have a term of up
to 5 years, but many are as short as 12 months . As a
For important disclosure information- see the end of this report.
ROTH CAPITAL PARTNERS, LLC
NETFLI X
Figure 6 - Netf1ix Shipping Centers, 2001-2003
1999 : First Overnight Marke t
looking at possible international market expansion after
2004 .
Indeed, pacing in markets serv ed by new shipping hubs
suggest Netflix may be on track to replicate the Bay
Area experience in other markets . After just 6 months
of one-day se rvice, Sacramento was at 2 .1%
penetration; Boston was at 1 .7°/o and LA was at 1 .3 ° o .
Figure 7 - Regional Penetration Curves
Kew Markets Follow Bay Are a
San F. Ln 8"Ana
0-I Million nousno ~
2002 : 36% US. Households
Reachable IN 0cc Da y
Source: Netfliz.
2003 : Over 60% One Day Coverage
Marketing Efforts Focus On Free Trial s
Netflix uses multiple Internet channels to attract
customers to the Company's 14-day free trial . Online
marketing includes pop-ups, pop-unders, banners and
direct e-mail marketing and all placements are pay-forperformance deals: Bring Netflix a sub and the
Company pays a bounty . In addition, the Company has
a number of third-party retailer partnerships such as the
one with Best Buy .com, which directs online
customers to Netflix for DVD rentals . The Company
also continues to use card inserts in most major DVD
manufacturer's packaging.
A significant amount of new business is driven by
word of mouth . Netflix reports that approximately 30%
of new subs are referrals from current customers .
Indeed, a high-level of satisfaction was unanimous
among customers we spoke to .
Once a customer is in the free trial, the merits of the
service itself takeover. In a market that enjoys one-day
Source : Netjlix .
delivery, the Company repo rt s that 90% of free tria l
Ultimately, m anagement ' s goal is to open hubs until subs become paying subscribers . These customers,
100% of subscribers can enjoy 2-day turnaround. After mostly male in Netflix ' s early adopter stage , are now
about 50% female .
providing this level of se rvice for a period of time ,
management believes it can achieve Bay Area-levels of
household penetration in eve ry market . Netflix is als o
For import ant disclosure information - see the end of this report .
ROTH CAPrrAL PARTNERS, LLC
NETFLIX
Integrated Systems Tie Demand to Supply Chain
Netflix's proprietary search software (CineMatch)
allows subscribers to find movies that suit their tastes .
The system doubles as an effective inventory
management tool by directing customers toward back
catalog titles and away from the newest new releases,
for which demand is often highest and wait times most
likely.
Historically, 70%-80% of a video chain' s rentals ar e in
new releases and 20%-301/o in catalog titles. The
opposite is true at Netflix, thanks to CineMatch . This
gives the Company a significant financial advantage,
because revenue sharing makes older titles more
profitable than new releases . (The distributor' s take on
the latter gets booked in the first 12 months of release . )
From the subscriber's perspective , Netflix adds value
to the home video rental experience by making its
catalog of 14,500 DVD titles ( easily 4x-5x more than
even the biggest video store) readily searchable and
matched to personal viewing preferences .
Most importantly, the title selection softw are ties
directly to the inventory and distribution management
system. Bar codes scanned at the shipping hubs
identify the location of every DVD in the supply chain .
Dem an d is determined by subscriber Rental Queue
selections , and the software automates fulfillment to
move the proper number of DVDs to the regional hubs .
Management Knows Retail, Softwa re ,
Entertainment and the Inte rn e t
Management combines a thorough understanding of
the home video industry with experience in online
sales and marketing, enabling them to anticipate and
respond successfully to industry dynamics and
competition.
Hastings' words have been vindicated almost to the
sub .
Reed Hasting s
Chief Executive Officer and Cofounder, 1997-present
Reed Hastings founded Pure Software in 1991 after
inventing the company s initial product, Purify . As
CEO, he led Pure Software to a 1995 IPO, completed
several acquisitions an d made it one of the 50 lar gest
public software companies in the world. After Pure
was sold to Rational Software in 1997, Hastings
founded NetFlix in the fall of that year .
Barry McCa rt h y
Chief Financial Officer, 1999-presen t
Prior to joining Netflix, Barry was Senior Vice
President and Chief Financial Officer of Music Choice,
a music programming service distributed over direct
broadcast satellite and cable systems. From 1983 to
1990, Barry worked with venture capital-backed and
LBO investments at Credit Suisse First Boston .
Tom Dillon
Vice President of Operations, 1999-presen t
Tom Dillon is responsible for fulfillment, customer
service, IT development and IT operations at NetFlix .
From 1998 to 1999, Dillon was CIO at Candescent
Technologies Corp., a manufacturer of flat panel
displays . For nine years prior to that, he was CIO of
Seagate Technology, responsible for IT functions in 30
factories worldwide . From 1984 to 1987, Tom served
as Senior Director of Manufacturing for IBM
subsidiary Rolm, and from 1980 to 1984 he was Vice
President of Manufacturing for Memorex .
Leslie Kilgo re
Particularly impressive is the IT background of Tom
Dillon, operations VP, who oversees the increasingly
efficient integration of Netflix's online customer
interface and the supply chain systems described
above .
It is also apparent that this team knows exactly how
and why their unique business model works . In
conversations with Reed Hastings in early 2000 - prior
to an IPO that would later be withdrawn - the CEO
identified net income break-even at what sounded like
an arbitrary one million subscribers . (At the time, the
Company had less than 200,000 subscribers.) Three
years and one massive dot-com meltdown later,
For important disclosure information- see the end oft/Ls report .
Vice President of Marketing, 2000-presen t
Leslie Kilgore is responsible for br and strategy,
customer acquisition, advertising an d PR at Netflix .
Prior to joining NetFlix, Kilgore was Mar keting
Director at Amazon. com . For seven years prior to that,
Kilgore was a Brand Manager for Procter & Gamble .
ROTH CAPITAL PARTNERS, LLC
NETFLIX
FINANCIAL MODE L
Each new Netflix subscriber is profitable . At the
current 7% chum rate and subscriber acquisition cost
of S35-S36, it takes approximately 20K new customers
to generate 50 .01 in annual earnings . Since we expect
nearly 500K new paid subs in FY03, we estimate a 2025 cent turnaround in EPS .
The external and internal factors described above, as
well as a number of other drivers, influence elements
of the Netflix financial model, as described below .
New Trial Subsc ri ption s
In 2002 Netflix more than doubled the number of new
trial subscriptions acquired, to more than 1 .1 M . We
estimate this figure will increase 42% to 1 .6M in 2003
and increase 20% to almost 2M in 2004 . The actual
results will depend on the following factors :
• General growth of DVD hardware sale s
• Growth of DVD rental as the preferred home
entertainment mediu m
■
■
Netflix's marketing expense commitment, and the
effectiveness of the campaigns
Competitor efforts to gain market share by
underpricing
Netflix's total addressable subscriber base is driven by
the number of U .S . DVD households, and the
Company aims to offer a 14-day free trial to every one
of them.
From 1998-2000, when most of Netflix's marketing
came in the form of card-in-the-box trials, Netflix
subscriber growth tracked with DVD hardware sales
growth. But Netflix sub growth began to lag the
industry in 2001, before the one-day-delivery-to-all
strategy was employed. Clearly, advertising inserts by
DVD manufacturers had become a less effective
marketing tool .
In 2002, word of mouth became much more significant
as a driver of new trials, as the opening of 12 shipping
hubs extended one-day delivery to more than one-third
of all subscribers . As a result, Netflix new trial sub
growth again outpaced DVD sales (88% to 66%,
respectively) . We expect that trend to continue, but our
projections call for that gap to shrink to single digits
this year and next, a conservative assumption based on
increased competition and management's desire to
preserve profitability by controlling marketing
expense .
For important disclosure information - see the end of this report.
With more than 1 million subscribers, Netflix has
established brand recognition in the space and has a
formidable first-mover advantage . Nevertheless, the
Company will face continued threats from
Walmart .com, Blockbuster's FilmCaddy .com .
Another point relevant to new trial subscriber growth is
the status of the ackaged home video window itself.
As discussed above under Industry & Competition, the
primacy of DVD rental among other home entrainment
choices is crucial to the continued success of Netflix,
Blockbuster or any of their competitors . When (if)
packaged DVD rental growth flatt ens with respect to
VOD, it would limit Netflix' s prospects . In such an
environment, the current rate of subscriber growth
could be sustained by the Company's own "electronic"
VOD offering .
Paid Conversion , Paid Retention and Chu rn
Netflix reports subscriber churn as a function of new
trial subscribers ; we used the Company's reported
figures to approximate the rate of free-to-paid
conversion and retention rate of paid subscribers,
which we feel are more useful metrics .
In 2002, reported subscriber churn was 6 .9%, up
slightly from 6 .8% in 2001 . By our estimates (see
below), free to paid conversion was 84% in 2002, up
11 points from 73% in 2001 ; and paid subscriber
retention was 79%, down from 83% .
We estimate churn will be 6 .9% in 2003, as free-topaid conversion falls slightly to 83% and paid sub
retention falls slightly to 78% . In 2004, we estimate
those metrics will be 6 .8%, 82% and 78%,
respectively . The actual results will depend on the
following factors :
One-day delivery capability of Netflix and its
competitor s
Continued superiority of Netflix selection software
General economic and employment climate
Management reports that 90% of new trial subscribers
become paid subscribers , but the Company does not
formally provide a free-to-paid conversion rate . Our
proxy for this metric is I - ratio of free subs to new
trial subs acquired during the quarter .
Netflix also does not report paid subscriber retention,
but a figure can be extrapolated using reported data and
the conversion proxy above . First, the free-to-paid
conversion rate of 83% multiplied by total new trials
during the quarter establishes the "optimum" numbe r
ROTH CAPITAL PARTNERS, LLC
NETFLI X
of new paid subscribers in the quarter (i .e . at zero
chum) . The difference between that number and the
actual number of paid subs added during the quarter
approximates the number of paids that quit .
Simply put, that ' s because the benefit of online
ordering fades quickly when subscribers cannot replace
the past weekend 's DVDs with new ones before the
coming Friday.
Subscriber churn, as reported by the Company, tracks
the same dynamic but uses different data to do so . The
concept is often misinterpreted so we thought it would
be useful to define it clearly here . The table below
provides an example of the Company's calculation .
Regarding other driversilimiters of paid conversion and
paid retention : Comparison shopping, as noted above,
will likely limit the number of new trials Netflix can
attract, but lower pricing at Walmart .com is bound to
cost Netflix some paid subscribers as well . However ,
we expect the impact to be minimal in all but the few
markets where Walmart .com. FilmCaddy. com and
others have established a one-day delivery capability.
Figure 8 - Understanding Churn at Nef lix
e .g .
Total subs (paid and free) at start of quarter 100
Total free trial subs added during the quarter + 90
Total subs (paid and free) at end of quarter - 15 0
"Churned" subs 4 0
Finally, the soft economy will be a non-specific limiter
of paid conversions and paid retention, not just for
Netflix but for any subscription service . Though home
video remains one of the cheapest forms of
ente rtainment , consumers are more likely to forgo or
cancel discretionary spending during periods of
economic uncertainty .
Total subs (paid and free) at start of quarter 100
Total free trial subs added during the quarter + 9 0
Total subs "in play " du ri ng the qua rter 19 0
Total Subsc ri bers
In 2002 Netflix ended the year with 857,000 total
subscribers , 796,000 paid and 61,000 free . On Feb . 27,
2003 the Company announced it had reached I million
total subscribers , midpoint of management guidance
for Q1 :03 . We estimate that Netflix will have more
than 1 .3M subs by year-end 2003 and close to 1 .7 M
subs at year-end 200 4
Churned subs 40
Total subs "in play" during the quarter / 19 0
Quarterly churn
21%
Monthly chum /3 7%
Source : Netflix company reports and Roth Capital Partners analysis.
Churn rate has been stable at close to 7% for the pas t
five quarters and appears "deeply demographic,"
according to the Company. As evidence, management
says chum in the San Francisco Bay Area, its best
market, is also close to 7% .
Despite pacing in markets with new shipping hubs, we
think it's unlikely Netflix will achieve penetration of
total U .S . households as high as the 3 .8% penetration
of the Company's home Bay Area market, which has
some obvious demographic advantages over other
major U .S . markets . (Higher penetration of DVD
households, for example .) Netflix's total U .S . HH
penetration is approximately 0 .8% today.
Churn varies seasonally and is generally higher in Q4,
when 30% of the year's DVD hardware purchases are
made, and Q I when many holiday-related 14-day trials
expire . Superficially, Netflix's churn rate appears high,
but it is comparable to the early adoption phase of
other entertainment subscription services such as HBO
and digital cable . We believe Netflix's efforts to bring
one-day service to all of its U .S . subscribers (from 36%
today) will reduce chum and drive growth.
Consequently, we think penetration of U.S . DVD
households is a better reality check for projected
Netflix subscriber growth . (A reasonable assumption
here is that a DVD home is also an online home .) In
the Bay Area, we estimate Netflix subs are in nearly
8% of DVD HH . In the U .S ., Netflix's DVD HH
penetration is approximately 2 .0% . At year-end 2003,
our estimates suggest Netflix will have 2 .1% U .S .
DVD HH penetration. With 1 .7M subs in 2004, Netflix
would be at 2 .2% penetration . We believe these are
very conservative benchmarks .
Whether we are discussing Company-reported churn or
our conversion and retention estimates, the superiority
of the Netflix product, esoecially the Comvanv' s
ability to provide one -day delivery to 60%-70% of its
subscribers by year- end 2003 , will drive subscriber
growth above all else .
ROTH CAPITAL PARTNERS, LLC
For important disclosure information - see the end of this report .
10
NETFLI X
Monthly Subsc ri ption Rate
We estimate that about one-quarter of Netflix
subscribers (including this analyst) are grandfathered
into a 4-DVD per month plan or another of the
different service tiers the Company has tested in the
past 5 years . However, the majority of subs keep 3
DVDs at a time and pay S 19 .95 per month - which is
almost exactly what the monthly revenue per average
paid sub came to in Q4 :02 .
For all of 2002, monthly revenue per paid sub averaged
S20 .20 . We do not anticipate pricing changes in the
near future, so S20 .20 is the figure we used to model
revenues in 2003 and 2004 . The actual results will
depend on the following factors :
Competitor efforts to gain market share by
underpricing
Any effort by Netflix to promote new service tiers
Any significant change in broad -market in fl ation
It is very impo rtant to note here that subscribers pay
their monthly subscriber fees in advance , by credit card
as registered online . Because revenue-share costs are
settled under traditional video industry terms (at the
quarter or annual close), Netflix generates significant
negative working capital needs. This cash flow - made
possible by beneficial timing of receivables and
payables - came to $7M in 2001 and $16M in 2002 .
We normalized this figure to S 13M in 2003 and 2004,
which could prove conse rvative .
Revenues
Netflix has more than doubled revenues in each of the
past two years, to S153M in 2002 from $76M in 2001
and S36M in 2000 . Based on subscriber growth and
the monthly subscription rate estimates above, we
project 2003 revenues of S250M, and S338M in 2004 .
Revenues also include a small amount of used DVD
sales - about S2M per year - that Netflix realizes in
bulk sales to video resellers . The titles an d volume of
DVDs sold is based on a periodic review of invento ry
vs . anticipated future rental dem and.
Netflix's subscription-based model provides a highly
visible top line , especially given the Company's
relatively stable churn and free-to-paid conversion rate,
plus the fact that the Company controls the reach of its
new trial offers and new trial hit ratio to new and
existing DVD owners .
DVD Acquisition (COGS )
New content is Netflix's largest cost at approximately
S58M in 2002, about 75°ro of total COGS and 4300 of
revenues . We estimate about half of that cost was in
shipping and half in revenue- sharing "upfronts " paid to
distributors . We believe this figure will nearly double
in 2003 to S 100M then increase to S 132M in 2004 .
The actual results will depend on the following factors :
• Netflix's ability, through the CineMatch software .
to manage demand for popular new title s
■ Any changes in revenue-sharing contracts with
major video distributor s
• Competitor efforts to over pay to accelerate
content acquisition and improve title selectio n
To acquire new DVDs, Netflix either purchases the
disks outright or, on 8 out of 10 titles, strikes a
"revenue sharing" agreement with the distributor . In
the typical deal, Netflix pays a small upfront fee per
disk plus a share of revenues for the first 12 months
after release . Upfronts are amortized over an
accelerated basis of one year. Some deals require a
prepayment of future revenue-share splits, which are
recorded as prepaid expenses on the balance sheet and
expensed as incurred . Other revenue-sharing splits are
expensed as incurred.
After the initial 12 months, Netflix can purchase the
title or return it. The Company typically reserves
enough copies to satisfy future demand then returns the
rest or sells them in bulk to DVD resellers . The DVD
release schedule determines seasonality in COGS,
which is weighted heaviest in Q2, when the previous
year's holiday movies typically hit the video window,
and during the Q4 holiday season .
As described above, Netflix' s title selection software
also functions as an inventory management tool . By
directing customers to back- catalog titles , matched by
previous rental tastes , Netflix is able to tu rn a
remarkable 95%-97% of its entire DVD inventory
every month . The system results in higher customer
satisfaction and just as importantly, helps control
revenue- share costs .
The "Big Six" distributors wield incredible power in
the video industry, so there is a risk that less beneficial
revenue-sharing terms could upset Netflix's economic
model, in spite of the Company's strong supplier
relationships .
However, we believe a dramatic shift in revenue-share
terms is unlikely, for several reasons . First, revenu e
For important disclosure information- see the end of this report.
ROTH CAPITAL PARTNERS, LLC
NETFLI X
sharing by definition gives the studios more of a vested
interest in their retailers' success . Second, by being one
of the first to cut DVD revenue - sharing deals, Netflix
was able to become a leading rental retailer, and the
Company now has some clout of its own (especially as
its order volume continues to climb ) . Last and perhaps
most impo rtant , the studios desperately want to
introduce more competition to the fold and move
Blockbuster into more DVD revenue sharing, and the
Netflix story provides leverage in this regard .
expect to see gross margins between 47%-18°b , on the
conse rv ative side of m an agement guid ance .
Library Amortization (COGS )
In 2002, amortization of costs on previously acquired
DVDs came to S17M, down 21% from 2001 . In 2003
we estimate DVD amortization will increase to $28M
and S40M in 2004 .
We believe there is further leverage in fulfillment
expenses even as the Company expands to more than
25 regional hubs this year; we estimate fulfillment
expense at $32M in 2003 and $43M in 2004, or about
12 .8% of revenues .
Amortization of DVD library costs increases over time
because in each subsequent qua rt er , Netflix purchases
more total titles . In 2001 the prescribed amortization
schedule was accelerated from three years to one year,
and the Company recorded a one-time adjustment to
catch up in Q 1 :01 .
The regional hub expansion strategy (described above
in Strategy & Operations) is based on the assumption
that within 50 miles of a hub, first-class U .S. mail is
the equivalent of overnight mail . Supporting this
assumption, and creating the fulfillment expense
leverage, is the increasing efficiency of Netflix's bar
code-based supply chain software . Operations chief
Tom Dillon has helped streamline not only the
shipping facilities - each is about 5,000 square feet and
costs just $60K to set up - but also the staff required to
operate it . Total fulfillment staff was 267 at year-end
2002 .
Fulfillment Expens e
Fulfillment expense is related to the operating of the
Company's 16 shipping centers . including the central
distribution hub in San Jose, CA. In 2002 this expense
was S 19M or about 13% of revenues, down from
almost 18% of revenues in 2001 when Netflix
operated only the San Jose distribution center) .
Shipping Expense (COGS )
Shipping expense to paid subscribers is recorded in
COGS ; shipping to free trial subscribers is recognized
in marketing expenses . Netflix does not break out
shipping costs separately, but we estimate they were
between S25M-$27M in 2002 or about one -third of
total COGS . We estimate the ratio of shipping to total
COGS will remain at 33% in 2003 and 2004 .
Subsc riber Acquisition Cost (Marketing )
Subscriber acquisition cost (SAC) is Netflix's second
largest cost next to DVD acquisition . In 2002 the
Company spent $36M marketing new trial
subscriptions to old and new DVD owners, using
Internet advertising, third-party promotions and ad
inserts in DVD boxes . Per subscriber, that amount
comes to an average of $31 in 2002 . This year we
exNct total marketing expense to increase to $54M, or
approximately $34 per new trial sub. In 2004 we
project $63M in marketing expense or about $37 per
new trial sub . Actual results will depend on the
following :
Netflix only ships by first-class U .S . mail ; its cost per
DVD is S0 .74 ($0 .37 each way). The U . S . Postal
Service occasionally raises rates , but rarely ahead of
inflation. Any change in our cost expectations here
would be identified early.
The more significant risk - because it's harder to
predict and quantify - is any threat to the reliabili ty and
speed of the U .S . mail . As the an thrax scare of late
2001 made the U . S . painfully aware, large-scale
delivery disruptions should be assumed into any
proj ection.
■
General growth of DVD hardware sale s
• Growth of DVD rental as the preferred home
entertainment mediu m
• Netflix's ability to maintain its product edge in
software, service and one-day delivery
• Effectiveness and nature of Netflix marketing
campaign s
• Competitor efforts to overspend on marketing to
gain share more rapidl y
Gross Pro fi t
In addition to DVD acquisition , libra ry amo rtization
an d shipping, total COGS includes intangibles
amo rt ization related to the studio equity- for-content
deal . Total COGS was $78M in 2002 , yielding a gross
margin of 49°%o . In 2001, Netflix ' s gross margin was
34% . Given our estimates and assumptions above, we
ROTH CAPITAL PARTNERS, LLC
For important disclosure information- see the end of this report .
12
NETFLI X
As DVD hardware penetration rates decelerate, each
mar ginal new trial sub will be more difficult ( and more
important ) to sell, driving up SAC . But Netflix' s rapid
move to one -day delivery across most of the U.S . will
help spur referral subs, which would exe rt a downwar d
bias on SAC .
Non-Cash Compensatio n
Nearly IM options were repriced at S3 .00 in 2001 .
Quarter to quarter, the rate of exchange an d the
expensable portion is uncertain . In 200i non-cash
compensation came to $10M, and we allow this
expense to increase to about S 14 .OM in 2003 and 2004 .
Regarding Netflix's decision on which marketing
channels to use (e .g . introducing TV ads) we are
generally ambivalent, as long as the paid sub
conversion rate is not decreasing while cost per
converted sub increases, which has not happened in
any quarter to date .
Being conservative , Netflix chooses to report non-cash
comp as a line item on the income statement, though it
is not required to do so . In Q4 :02, twvo-thirds of this
expense was fixed at S2 .1M (Q4 :02) . The balance was
variable , based on stock price on the last day of the
quarter, which obviously cannot be forecast .
However, some pressure could be exerted on those
ratios by the efforts of competitors . Our allow ance for
increased SAC over the next two ye ars presumes a
gradually increasing competitiveness from
Walmart . com and the likelihood the p ar ent company
will use its ample cash to fund DVD rental as the lossleader for online sales. Today that cost would be as
substantial as it was for Netflix in 1998 - 1999, with
SAC ranging from S 100-$200 .
Net Interest Income
Netflix has zero debt, after taking a S l OM charge for
non-cash interest due to early repayment of notes in
Q2 :02 . Going forward, we allow for zero interest
expense and only marginal interest income of about
$300K per quarter .
Taxes
Netflix pays no income tax because it has yet to post
any pre-tax income. The Company carries
approximately $88M in net losses from previous years,
which it can use to shelter future income from federal
tax liability through 2012 . NOLs for California income
taxes are $57M and expire between 2002-2012 .
Of course, one could argue that Netflix should spend
the marketing doll ars now, while its first-mover
advan tage is still substan tial, but we believe the
Company's emphasis on profitability is the right
priority at this time .
Free Cash Flow
Given the volume of back-catalog rentals at Netflix,
the revenue-generating life of each DVD is clearly
longer than one year, so the accelerated 12-month
depreciation understates EBITDA. We believe this
anomaly, and the cash generated by negative working
capital needs, makes free cash flow (FCF) a better
gauge for near-term growth than EBITDA .
Technology & Development Expense
Technology and development spending consists of
expenses to update and improve the website, including
the CineMatch software and systems infrastructure . In
2002 that expense was almost $9M or 10% of
revenues , down from S12M or 23% of revenues in
2001 . We use management guid ance here to estimate
T&D at $9 .5M this year and $12 .7M in 2004 . The
only significant risk here would be the cost of software
engineering, but it' s a buyer ' s market for such talent in
Silicon Valley. Netflix employed 64 T&D staff at yearend 2002 .
In 2002 Netflix generated $15 .8M FCF, mostly from
working capital . Based on the estimates and
assumptions in the income statement elements above,
we project $27 .4M FCF in 2003 and $48 .5M FCF in
2004 , most of it from operations .
General & Administrative Expens e
In 2002 G&A was $6 .7M and we expect this expense
to remain relatively steady as a percent of revenues
over the next several years . A downward bias is
exerted by Netflix's web-based software for customer
help and supply- chain management. It has allowed the
Company to reduce its customer service staff from 80
in 2000 to 50 in 2002 . Total full-time G&A staff at
year-end 2002 was 31, part-time and temporary staff
was 114 .
Our FCF calculation takes Net Income , adds back
D&A and all non-cash items , including stock-based
comp ; subtracts DVD cost and other capex ; then adds
net change in working capital .
Net Income
Netflix has yet to post positive net income (on GAAP
principles) but in Q2 :02 the Company broke even on
proforma net income for the first time . (Profornia net
income excludes non-cash compensation and one-tim e
ROTH CAPITAL PARTNERS, LLC
For important disclosure information- see the end of this report .
13
NETFLIX
Substantial Sho rt Position In The Stock Toda y
As of our initiation date , more than 4M shares had
been borrowed and sold against a future decline . This
short interest amounts to approximately lOx the
average daily trading volume . Short covering could be
a near-term catalyst for the stock .
items ) . In Q4 :02 Netflix recorded S463K in proforma
net income or $0 .02 per share .
If our estimates above are close to actual results,
Netflix can deliver positive GAAP net income in at
least one quarter this year, and for the entire Year of
2004 .
Management Owns 15%, Institutions Own 72 %
The table below identifies significant NFLX
shareholders . The largest NFLX shareholder is
Technology Crossover Fund (16 .110), then CEO Reed
Hastings (11 .4%) . Altogether, institutional investors
own 72% of the Company .
Share Coun t
Outstanding common shar es in Q4 :02 were 22 .2M .
However, Netflix may have significant share dilution
when it becomes GAAP profitable. As of year-end
2002, investors held 4 . IM outstanding options at an
average strike price of $3 .42, 1 .3M of which were
exercisable . The Company also has 6 .3M warrants
outstanding at a weighted average exercise price of
$3 .23 .
Convertible preferred sh ares ( including the Series F
preferred stock issued to the major studios in retu rn for
revenue - share deals in 2002 ) were converted into
common sh ares at the May 2002 IPO .
VALUATION & TRAD IN G
Figure 9 - Major Shareholders
We believe adjusted free cash flow (FCF ) is the most
reliable gauge of Netflix' s growth prospects . For
valuation purposes , we chose to adjust this figure to
make it even more conservative , by effectively
expensing non-cash compensation.
Total Shares utstandin
22 2'
14 8 0 '
2 .53
0.67
0 .08
11 .4 %
3 .0%
0 .44:
3 .28
14 .8%
Institution s
Technology Crossover (Jay Hoag)
Fred Alger Fund
3 .57
2 .15
16 .1 %
9 .79 :
Finanzas N .V . (Maria van der Sluijz )
2 .04
9 .2 %
Foundation Capital Mgmt ( Michael Shuh )
Institutional Venture Mgmt
Arbor Capital
Essex Investment Mgmt
RS Investment Mgmt
Bridget Management
1 .74
1 .69
1 .40
0 .94
0 .89
0 .31
7 .8%
7 .61/6
6 .3 %
4 .2%
4 .0 %
1 .4 %
16 .00
72 .0 %
0 .79
3 .6 %
Officers and Directors
Reed Hastings (CEO)
Marc Randolph (VP)
Others
As Group
Using our adjusted FCF estimates of $13 .4M in 2003
and $34 .6M in 2004 , growth of FCF at 35% from 2005
- 2007, adding a terminal value of 6x year-five FCF
then discounting at 20 %, we arrived at a NPV for
Netflix cash flows of approximately $340M or about
$15 .30 per share . Adding cash per share of approx.
S4 .70 yields a $20 price target .
We believe it is premature to value NFLX shar es using
an earnings multiple, but for investors who prefer P/E,
our S20 target is supported by an enterprise value of
30x FY04 diluted EPS.
ALL Institutions
Other Public
Source: Company filings.
Recent Insider Activity
The lock-up on essentially all of the pre-IPO shares
expired in Nov 2002, and the stock's recent run has
prompted some limited 144-related insider selling by
Thomas Dillon, Leslie Kilgore and Reed Hastings . In
particular, Hastings and Dillon have been selling small
blocks since Nov . 2002 .
In our opinion, no suitable public-market comparable
exists for Netflix.
NFLX Shares Were Volatile in 2002
Netflix conducted an initial public offering at $17 per
share on May 29, 2002 . Since then NFLX stock has
seen some dramatic swings in value. Five months after
the IPO, NFLX dropped to $5 .22, partly due to the
launch of Walmart .com's DVD-by-mail service in
September . NFLX shares recovered to the mid-teens by
2002 year-end, thanks to the Company's continued
subscriber growth in spite of a well-capitalized new
competitor .
Investment Risk s
Impediments to Netflix's financial performance, and
reasons why NFLX shares may not reach our price
target, include but are not limited to the following :
ROTH CAPITAL PARTNERS, LLC
For important disclosure information - see the end of this report.
14
NETFLI X
• Increasing competition and price pressure on
Netflix subscription se rv ice s
• Netflix' s relationships and contract terms with
movie content owner s
• Consumer acceptance of the DVD video format
■
Consumer acceptance of Netflix products and
service s
■
Netflix's ability to make timely and reliable
delivery of DVD s
• Research and technology development costs in a
rapidly changing environmen t
■
Uncertain political and economic climate and the
disruptive threat of terrorism .
Investors should also review the Company's 10K for a
detailed description of industry and market risks .
ROTH CAPITAL PARTNERS, LL C
For important disclosure information- see the end of this report .
15
NLFrt_)X
NEIFLI X
All figures in Smil
REVENUE
%changeY -Y
"'.. change Q.Q
2000
5.0
274•/.
no
Mar-0 2
QI :02
FY
2001
1`11 '
FY
1999
35 .9
617%
no
Jun -0 2
02 :02
Sep-0 2
3 :02
75.9
30. 5
36 .4
111•/.
no
79.0 %
98 .1 %
41,2%
19.1%
40 .7
1158 %
120"'°
50.2%
4 .7
16 .0
0 .8
21 .5
19 3
47 .3%
4 .9
12 .0%
2 .9
40
11, 5
0 7
13 .3
15 1
18. 1
15 4
50.3%
Dec-0 2
Q4 .02
Mar-03 Jun-0 3
Q1 :03E Q2 :03E
FY
2002
45 .2
109 .0%
11)9%
152.8
101 %
no
60 2
65 .6%
12 .7%
F'Y
2003E
Ure-03
Q4 03E
F' Y
2004 E
249 .7
70 9
569%
8( 1
28 0
0 9
36 8
34 1
4% I".;,
47 .5%
40.0
132 -3
3 .2
175 .5
162 .4
48 .1 %
%
12 .5,,
32 .1 1
12 .8 %
43 .2
12 .8%
12 .7
14.0
26. 7
7 .9 %
8%
63 %
35'/.
no
no
0 8
0 8
28 . 2
25 . 2
31 3
28 .9
47 .2%
48 0%
7.0
13 .2%
7.8
13 .W9i .
% 2
12 .6%
8. 7
5. 9
14. 6
9.6%
1 .9
1 .5
3 .4
6 3%
2 .2
1 5
3 .7
6.2%
2.6
2. 0
16
70%
6. 8
96%
9. 5
9 .0
18 .5
7 .4•/.
12 .2
48 .2 9, (
5.4
12 .1%
19 .4
12 .7'/.
61 )
7 0
21 .4
23 . 5
337 .9
65 .2
600%
8 .2°6
7 0
27 . 1
0%
34 .9
10 . 3
46 .5°6
17 . 4
57 . 5
3.1
78. 1
74 .7
48.9%
5 .8
53 . 4
75 .0 %
1 9 2%
Sep-0 3
Q3 :03E
28 .0
33.3%
32A%
22 . 1
25 .6
2.2
49 .9
26.0
34 .3 .
Fulfillment
Fulfillment % ofrevenue
2.4
48 .9%
10 .2
28 .5%
13 .5
17 .7•/.
4 .2
13 .6%
4 .9
13 .3%
R & D Expense
PPE Depreciation
Total R & D
R & D % of revenue
0 .0
0 .9
0 .9
17.7%
13. 1
3. 7
16.
8
46. 9%
12 .2
53
17 . 7
23 .4%
1 .7
1 .5
3 .2
10.4%
2.1
1.4
3.5
9.7%
9 .7%
2 .5
1 .4
4 .0
8 .8'%,
14. 1
281 .1%
25 .7
71 .7%
21 .0
27.7%
7 .9
26 .0%
8.1
22 .2%
9 .3
22 .8%
10 . 5
23 . 2%
35 .8
23 .4 %
14 . 0
26 .2%
202%
12 .6
193%
15 .2
21 .4%
54 .0
21 .6%
18.7 %
2.0
39 .8%
7 .0
19 .5%
4 .7
6 .1%
1 .3
4 .3°G
1 .6
4 .5%
1 .9
4 .6%
1.9
4 .2 %
6.7
4 .4'/.
2 .4
4 .5°.0
2.7
4 .5°6
2 9
4,5%
3.2
45%
11 . 1
4. 5%
15 . 1
4.5%
26 .8
61 .6%
26. 4
46 .4%
28 . 3
41 .2%
34 . 0
5591/1 ,
115 .6
51%
148 . 2
28 %
14. 0
0 .0
0 .0
0 .2
Amortized DVD Library Cost
Rev . Share Payments and Other COG S
3 .2
0 .2
15.7
w .
Intangibles Amor(
0 .0
0. 5
Total COG S
Gross Profit
GP Margin
Marketing
Marketing % of revenue
G, & A
G&A%of revenue
Total Operating Expense s
% change Y-Y
3 .3
1 .7
8.0
24-3
11 .6
08
18 3
2 4
1 .6
4 .0
16 .7
0 8
23 .4
21 . 8
19 .4
nm
59. 8
208 %
56.9
-5•/.
16.6
-3 .9%
18. 1
32 . 8%
20 0
64 .4 %
21 .8
5791%
76. 5
35•/.
4. 7
0. 0
0 .0
5 .7
0 .0
0 .7
(37 .2)
2 .8
00
0 .0
(4 .1)
2 .7
0 .0
0 .0
(25 )
1.5
0 .0
0 .0
( _3)
2 .8
00
0.0
(_8
9 .8
0 .0
0 .0
(11 .7)
0.5 10.9
( 45) (13 .4 )
(06 )
11 .7)
(0.5 )
12_3)
Tax Provision
Effective TaxRare %
0. 0
0 .0%
0 .0
0 .0%
0 .0
0.0%
0 .0
0 .0%
0 .0
0 .0%
0,0
00%
0 .0
0 .0%
NET INCOM E
Net Incomenurgin
(22_1 1
-445•/.
(57. 4 )
-160 %
(3 11.6 )
-51%
(4 .5)
-15%
( 13 .4 )
-37%
(17 )
4%
1 .4 1
1 .41
14 . 1 0
14. 10
EPS (GAAP )
FPS diluted (GAAP)
Profonna Net Income (before non-cash con?
Profornn diluted EPS
17 .5 7
1757
21 .9 2
2192
.30 1
( 15.9 8) (41) .57 ) (2 .7 4 ) (1)
( 15.98 )
4411 .57 ) 12 .74 ) 11 .30)
(11 .76 )
10]6)
(00% )
( 32 .9 ) (I I )
(17 5 ) (48 .1 1
) 100%)
1(2 .5X ) (33.99) (234
000
For important disclosure information - see the end of this report .
(0 )1%)
0 .0
111 1 )
(111%1)
(1 .2 )
(9.X)
11 .2 )
1 .4
0 .0
0 .0%
0. 0
0 (1%
0 .0
00%
0 .0
00°)
0. 0
0 . 0%
0. 0
0 .0 %
(4 7 )
-9%
(1) 6 )
-1%
(1 0)
-I, ;
(15 )
(9 .111 (
-4%
1 .4
0%
(22 .0 )
(22 3 )
-5%, -14%
1 .4
(38.6 )
14 .8 3
14 .83
to 3 )
(15)
0. 0
0.0%
(11.2 )
(57 .4)
1 .3 9
1 .3 9
(0 .3 )
( I (1)
(03 )
(4 7)
(0 .2 )
122_11
Average shams o ur
Average diluted shares
(111)
(0 .3 )
Interest Expense (Income) incl . no n-cash i n
PRE-TAX INCOME
22 . 2 2
22 .22
19 .1 4
19 .14
22 5 2
22 .52
(I)II )
(1 .1 5 ) 11121 )
It II) I 11 .15 ) 10 21)
0.5
0 .02
63 .3
13 .9
0 .0
0 .0
111 .111
10. 3
(22 .0)
(22 .5)
118 .5
(1 0
0 .0
11%)
3 3
0 .0
0 .0
(09)
8 .8
0 .6
0.0
(57.6)
4 0
3 .2
131 .2
33
0 .0
0 .0
(13)
3 5
0.0
0. 0
(5 . (j )
Non-Cash EE Com p
Non-EEtCom p
Restructuring Charge
OPERATING INCOME (LOSS)
2.8
100. 0
41 3 )
(0 . 8 )
111.114 ) (I) )ill
22 .6 7
22 .67
(0 (1 ' 1
(u 0?)
2 8
0 12
22 8 2
22 .%2
3 9
-51,G'
22 .9 7
2297
22 .7 5
22 .75
2335
30 .8 5
0.11 6
(11.43 )
111 .41 1 011 4
(1 1) 1 )
Io (14)
(II I s )
lU 15 1
2 1
1) 10
"1 :,4
4 .2
15 3
2
1,18
0.511
----------------------------------------------------------------------------------------------------- -----------' ._-------------------------ROTH CAPITAL PARTNERS, LL C
16
NETFLIX
NETFUX
% of
BALANCE SHEET
FY FY FY Tota l
All figures in $ mil
2000 2001
200 2
W-Iw~dqF NTT rT"11r!
-wig SERF-M
-," t
ASSETS
Current assets :
Cash an cas equiva ents 14. 9
16.1
59.8
46 %
0.0
0 .0
43.8
34 %
rrepaio expenses
2.7
1 .0
2.8
2%
Prepaid revenue- sharing expenses
Other current assets
0 .6
0.0
0 .7
1 .7
0.3
0.4
0%
0%
18.3
19 .6
107.1
82%
Property and equipment, net
10 .0
8.2
5.6
4%
DVD library ( net of depreciation)
16. 9
3.6
10.0
8%
Intangible asset s
5 .6
7 .9
6.1
5%
Deposits
0.6
1 .7
1%
Other assets
1.1
0 .6
1 .7
0.1
52.5
41 .6
130. 5
100 %
Accounts payable
7 .7
13 .7
20 .4
49 %
Accrued expenses
5 .9
4 .5
9.1
22 %
Deferred revenues, net
Current por ti on of capital leases
2 .8
4 .9
9 .7
24 %
1 .3
1 .3
1 .2
3%
Notes payabl e
2 .3
1 .7
0 .0
0%
20 .0
26 .2
40 .4
98 %
Capital lease obligations
2 .0
1 .1
0 .5
Defe rred rent
0 .1
02
0 .3
1%
1%
a eta
a secur ities
Total curare nt assets
TOTAL ASSET S
0%
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabil it ies :
Total cu rrent liabilities
1 .8
2.8
0 .0
0%
23 .9
30 . 3
41 .2
100 %
Commitments and contingencies :
Redeemable convertible pref. stock
101 .8 101 .8
0.0
Stockholders' equity :
Preferred stock, $ .001 par, 8 .5M shares authorized ; none
0 .0
Common stoc k
0.0
Additional paid- in capital
Accumulated deficit
0.0
0.0
0.0
0. 0
34 .6
(98.6)
52 .5
(137 .3)
259. 2
(159. 2
Deferred stock-based compensation
(9 .3)
(5 .7)
(11 .4
Accumulated other comprehensive income (loss)
0 .0
0 .0
0. 8
(73 .3)
(90 .5)
89.4
52 .5
41 .6
130 .5
Total stoddwlders ' equity
TOTAL LIABILITIES AND EQUITY
For important disclosure information - see the end of this report .
ROTH CAPITAL PARTNERS, LL C
17
NETFLIX
NETFUX
CASH FLOW STATEMENT
All figures in $mil
_
FY
FY F Y
2000
2001 2002
Pd.
NET OPERATING LOSS
(57 .4)
(38.6) (22 .0 )
Adjustments to reconcile net loss to net cash provided by
operating activities :
Depreciation of PPE
Amortization of DVD li brary
Amortization of intangibles
3 .6
15.7
0.5
0 .6
8.8
Noncash charges for employee option awards
Stock-based compensation expense
5.5
5 .9
22.1
2.2
0.0
17 .4
3.1
0 .1
5.7
0.0
0 .0
9 .8
0 .0
0 .0
0 .5
0.0
1 .0
(1 .7 )
11 .4
Prepaid expenses and other current assets
Accounts payable
(2 .7)
2 .4
Accrued expenses
Deferred revenue, net
Deferred rent
NET CASH PROVIDED BY OPERATING ACTIVITIES
2.7
2.3
0 .1
(0.0)
6.0
(1 .4)
(0 .0 )
6 .6
4 .6
2. 2
0.1
4 .8
0 .0
( 22.7)
4.8
40. 1
0 .0
6.3
(6.2)
(23 .9)
0. 0
0.0
(3.2)
(8.9)
(43.0)
( 2. 8)
(24.1 )
0 .0
(1 .2)
0.0
(0.6)
(12.7)
2 .0
0.6
(67 .3 )
0.0
0.0
88 .0
0. 0
Loss on disposal of property and equipment
Gain on disposal of DVDs
Norxash interest expense
Changes in operating assets and liabil ities . net of acquisitions :
Purchases of short-term investments
Sale of short-terra investments
Purchases of property and equipment
Acquisitions of DVD library
Sales of DVDs
Deposits and other investments
NET CASH USED IN INVESTING ACTIVITIES
(25 .0)
Proceeds from issuance of redeemable conver ti ble preferred stock
Proceeds from issuance of common stock
50.0
0 .4
Proceeds issuance of sub. debt and detachable warrants
Repurchases of common stock
0 .0
( 0 .1)
0 .0
( 1 .9)
Proceeds fro m issuance of notes payable
Principal payments on notes payable and capital lease obliga ti ons
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES
Net increase (decrease) in cash and cash equ ivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
0.1
12.8
(0.0)
0.0
48 .4
(3.9 )
9.1
0 .7
14.2
1 .2
14 .9
14.9
16.1
(0.0 )
0. 0
(17 . 1
70.9
43. 7
16. 1
59. 8
Supplemental disdastue:
Cash paid for interest
0 .9
0.9 0.6
Non-cash investing and financing a ctivities :
Purchase of assets under capital lease obligations
Discount on capital lease obli gation
Warrants issued as deposit on operating lease
Exchange of Series F non-voting convertible preferred stock for intar
Unrealized gain on short-term investments
Conversion of convertible redeemable preferred stock to common st
3 .0
0 .1
0 .2
6 .1
0 .0
0 .0
0.5 0.0
0.2 0 .0
0.0 0 .0
4.5 1 . 3
0.0 0 . 8
0 .0 101 . 8
ROTH CAPITAL PARTNERS, LLC
For important disclosure information- see the end of this report .
18
NETFLI X
Other Public Companies Listed in This Report :
Wal-Mart Stores Inc . (WMT- $49 .55 - NR)
Blockbuster Inc . (BBI - $16 .90 - NR )
Hollywood Entertainment (1-ILYW - $15 .32 - NR )
ROTH CAPITAL PARTNERS, LL C
For important disclosure information- see the end of this report .
19
NETFLIX
Disclosures :
Investo rs should assume that Roth Capital Pa rt ners, LLC ("RCP"J expects to receive or intends to seek compensation for investment banking or other
business relationships with the covered companies mentioned in this report in the new three months.
Specific Disclosures:
(al Within the last thirty-six months, RCP has managed or co-managed a banking transaction for this company . This research contains forward-looking
statements made pursuant to the safe harbor prof ision of the Private Securities Litigation Act of 1995 .
(b) RCP makes a market in this security.
(c) RCP and'or its employees, officers, directors and owners own options, rights or warrants to purchase this securav.
(d) An employee of RCP serves on the company's Board of Directors (other than the Research Analyst) .
ie) A Research Analyst andior a member of the Analysts household has a financial interest in the securities of the subject company (if applicable . specific
type of financial interest owned will be disclosed) .
(f) The Research Analyst serves on the company's Board of Directors.
(g) This security is not eligible for sale in one or more states .
(h) This stock is subject to the Securities and Exchange Commission's Penny Stock Rules, which set forth sales practice requirements !or certain loir-
priced securities .
(it Within the last twelve months, RCP has managed or co-managed a banking transaction for this company.
(i )
Within the last twelve months, RCP has received compensation for investment banking servicesfrom this company.
(k) RCP or its affiliates beneficially owns 1% or more of an equity security of this company.
Ratings Dist ribution:
Strong Buy / Buy
Neutral/NR
Sell
R Ingrassia - Rich Media IT & Entertainment Coverage
R Ingrassia - Rich Media IT & Entertainment Coverage - Investment banking relationships'
l000,
0°'.
0°' o
00,0
0°-„
O° O
Global Coverage
'~o 0
170
23°
9°.o
00"'.
On .
Global Coverage- Investment banking relationships'
Within the last twelve months, Roth Capital Partners has received compensation for investment banking services from this company.
Ratings S ystem Definitions - RCP employs a rating system based on the following
Strong Buy : A secwxy, which at the titre the rating is instituted and or reiterated indicates an e xpectation of a total return ofat least 40% over the next 12
months
Buy : A security, which at the tine the rating is instituted. indicates an expec tatio n of a total re turn between 10% and 40% over the ne xt 12 months.
Neutra l : A security, which at the tire the rating isinstituted , indicates an expec tation of a total return between negative 10% and 10% over the next 12
months .
Sell : A security, which at the time the rating is instituted. indicates an expectation that the price wig deprecate by more than 10% over the next 12 months.
Our rating system attempts to incorporate industry, company and/or overall market risk and volatility . Consequently, at any given point in time, our
investment rating on a stock and its implied price movement may not correspond to the stated 12-month price target .
a ..~nvra, ~m „, x
NFLX
Initiating Coverage
03/14/03 $16 .25
Tar get: $20.00
. . ..... . .,.
.mow, r r ...
C rrM~ . .~ rte. .
For historical disclosure information , please see link below :
httn :/ww w .investors. com/cei-hin/cha rts/ nasdag. exe?f=1&s=nllr&a=66&re=1
http :/www' . investars. comicomnliancetools'ratinrs csv .asp?symbol = nllx&filename =NFLXO4072003 .csv
The material information and facts discussed in the repo rt other than the information regarding Roth Cap ital Partners, LLC ('RCP') and its affiliates, are
from sources believed to be reliab le, but are in no way guaranteed to be comple te or accurate. This repo rt should not be used as a comple te analys is of the
company, industry or security d iscussed in the report. Additional information is available upon request. This is not, however , an offer or solicitation of the
securities discussed. RCP may trade for her own accounts as odd - lot dealer, market maker and/or b lock posuoner in any securities of this issuer(s) or in
related investments, and may be on the oppos ite site of public orders. Any opinions or estimates in the re port are subject to change without notice . An
investment in the stock may involve risks and uncertainties that could cause actual resu lts to differ materially fr om the forward- looking statements .
Additionally, an investment in the stock may involve a high degree of risk and troy not be suitab le for all investo rs . No part of this repo rt may be
reproduced in any form without the express written permission ofRCP . Copyright 2003 . Member: NASD/SIPC .
ROTH CAPITAL PARTNERS, LL C
For important disclosure information- see the end of this report.
20