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Netflix, Inc: Equity, Cash Flow, and Notes Analysi

Netflix, Inc: Equity, Cash Flow, and Notes Analysis

TEAM A:

ACC529 Accounting for Managerial Decision Making

July 7, 2004

ABSTRACT

In the following paper, the authors select Netflix Inc, a publicly traded company, and analyze the firms year-end financial reports in order to explain the components, and discuss the meaning, impact, and potential strategies brought to light by the reports. Particular attention is paid to the Statement of Cash Flows and the Statement of Owners Equity, but a brief mention of the other financial data is presented as well.

Netflix, Inc: Equity, Cash Flow, and Notes Analysis

Introduction
Netflix achieved profitability for the first time in 2003. The Company recorded revenues of $272.2 million, up 78 percent compared with $152.8 million for 2002. Net income was $6.5 million, compared with a net loss of $20.9 million in the prior year. This strong financial performance was driven, in part, by their rapidly increasing subscriber base, which grew to nearly 1.5 million members, up 74 percent over 2002.

Netflix has succeeded in becoming a truly integral part of the consumer entertainment landscape. At year-end 2003, Netflix had approximately 95 percent of the fast-growing market for online DVD movie rentals.

Customer satisfaction is high, because they have the movies that our subscribers want. The Netflix model is based on giving todays movie consumers a combination of convenience, value and selection that appeals to a broad and diverse group of people  not just avid movie fans.

Statement of Changes in Owners Equity Statement

(Please see Exhibit 1 on the following page.)

Components of the Report

Netflix Inc has chosen more of a spreadsheet format for the presentation of their Statement of Owners Equity (hereafter OE) and Comprehensive Income. This form keeps a running total of the OE from one year to the next, and details the actions taken by the firm that have had an impact on the total amount.  The components of note in the

Exhibit 1  (Netflix, 2004)

Statements are of course the net income from the years operations, additional paid-in capital, and those monies earned through the issuance and sale of the firms common stock.

Analysis and Strategy
The Statement of OE paints a picture of very positive trend in the accumulation of OE on behalf of the shareholders.  For the second year in a row, the statement shows a positive amount of equity, having grown by 126% from the previous year (end of year 2002).  The statement also shows that 2003 was the first year in which the company posted a net sales profit for the year. As opposed to the %36 Loss on Equity calculated from the balance and income statements from 2002, we see that in 2003 we can calculate a positive Return on Equity (hereafter ROE) to be:

Total OE, December 31, 2002:         89,356,000

Total OE, December 31, 2003:         112,708,000

Net Income, December 31, 2003:     6,512,000

ROE = 6,512,000 / ((89,356,000+112,708,000)/2)

ROE = 6%

The statement also shows that most of the increase in OE for the year of 2003 occurred due to the actions taken with regard to common stock, selling well above the stated par value of $.001, the greatest gains for OE were made regarding the amounts contributed above and beyond that par value, known as Additional Paid-In Capital.  Such a positive accumulation of such capital reflects that investors look favorably upon the future of the firm and its potential to make the shareholders money in the future.  They must be attuned to the positive trend in profitability and ROE.

The best counsel we can give with regard to strategies uncovered by the financial data presented in the Statement of OE is that continued growth of ROE and Net Comprehensive Profit will further boost investor interest and confidence in Netflix Inc, leading to increased financing activity, or Paid-In Capital, which together with greater retained earnings will afford the firm the assets its needs to appropriately balance the operational and investment actions needed to nourish and grow the organization. The firm may want to consider in 2004 the payment of dividends for the first time in its history. While the amount of the dividends should be minimal, their mere existence may highlight the increased ROE and Net Profit, further convincing the shareholders that their wealth is increasing and that Netflix is a company in good standing.

Statement of Cash Flows

(Please see Exhibit 2 on the following page)

Components of the Report

The Statement of Cash Flows provides information concerning a firms cash inflows and outflows during an accounting period.  Most Balance Sheets and Income Statements are prepared using accrual-based accounting; the Statement of Cash Flows adjusts the information provided by the Balance Sheet and Income Statement to reflect actual cash flow.  There are three main classifications:  operating activities, investing activities, and financing activities.  An organization can choose from two methods of preparation: direct and indirect method.  The only difference between the two methods is how operating activities are reported.

This statement includes only transactions that involve cash, and is useful to determine how effectively cash is being used within an organization and helps to determine their overall financial health.  It not only indicates whether or not extra cash is available, but also which area of the firm would benefit the most from the cash.  Manage-ment can make better decisions by analyzing this statement to determine if they are able to meet their debt payments or if outside funding is necessary (Marshall, 2004).

Exhibit 2  (Netflix, 2004)

Analysis and Strategy
Netflix, Inc. filed Form 10-Q with the Security and Exchange Commission on February 27, 2004.  The Statement of Cash Flows was reported in the indirect method.

Net income of $4,720,000 was reported on the Income Statement.  This figure was increased from the net loss of $20,948,000 reported for year ending 2002.  Net cash provided by operating activities increased from $40,114,000 in 2002 to $89,792.000

In 2003.  This was largely contributed by an increase in the amortization of the DVD library as a result of increased purchases of titles in 20036, an increase in accounts payable as a result of the growing operation, an increase in deferred revenue because of the larger customer base, and an increase in stock-based compensation expenses.  The increase in net cash was offset by the decrease in non-cash interest expense in 2003, which included a one-time charge of $10.7 million due to an early debt repayment in 2002 (Netflix).

There was a decrease in net cash used in investing activities, primarily due to smaller purchases of short-term investments in 2003.  This decrease was partially offset by the increase in purchases of property and equipment needed to support the increase in subscribers.

Financing activities reported a decrease in net cash provided, due to smaller proceeds from the issuance of common stock in 2003, offset by a decrease in the repayment of debt and other financial obligations in 2003.

It was a very successful year for Netflix.  They experienced a substantial increase in cash and cash equivalents from the beginning of the period to the end of the accounting period.  After enduring a net loss for 2001 and 2002, their strategic planning of increasing subscribers along with increasing their DVD library met with success.  Our suggestion would be to continue the trend, but also refer to this statement to determine if any financial difficulties are in the future, and take the necessary action for avoidance (Netflix).

Report Notes and Other Information

Notes on Common Stock

The information given in the Notes to Financial Statements section is important to investors because is details the actions taken with regard to the companys stock since its inception.  This gives an information seeker or potential investor the ability to piece together the management logic behind the transactions.  For example, based on the notes in Netflixs 2003 End of Year Report, we see the explanation of their Employee Stock option plan, which began in February of 2002, and for which we see line item transactions listed in the Statement of OE. For example, from this we know that employees purchased $1.3 million in the firms stock through their employee stock option program.  We can also see, based on the description of the stock option program in the notes section, that just about all of the stocks allowed to be sold to employees in 2003 were purchased, showing an investor that employee confidence in the company runs strong. This can be important to an outside investor looking to piece together a sense of the corporate culture of the firm.

Notes on Amortization

In January 2001, Netflix shortened the estimated the life of DVD library to one year, and assumed a salvage value of $2.00, which would eventually be sold.  Prior to this change, the costs of DVDs were amortized using a sum-of-the-month accelerated method over the estimated life of three years with no salvage value.  This change was beneficial in year 2003 because of the increase in the DVD library, and an increase in amortization from $17,417,000 in 2002 to $43,125,000 in 2003 (Netflix).

Netflix acquire DVDs from studios and distributors either through direct purchase or pursuant to revenue sharing agreements. These revenue sharing agreements enable us to obtain DVDs at a lower up-front cost than under traditional purchase arrangements. Netflix then shares a percentage of the actual net revenues generated by the use of the DVDs associated with each particular title with the studios over a fixed period of time, which is generally 12 months for each title. At the end of the revenue sharing period for each title, they have the option of either returning the DVDs associated with the title to the studio or purchasing some or all of those DVDs.

Netflix amortize the cost, less salvage value, of our DVD library on a “sum-of-the-months” accelerated basis over one year.

Under their revenue sharing agreements, they remit an upfront payment to acquire DVDs from the studios. This payment includes a contractually specified initial fixed license fee that is capitalized. Certain of these payments also include a contractually specified prepayment of future revenue sharing obligations that is classified as prepaid revenue sharing expense and is expensed as revenue sharing obligations are incurred. The initial fixed license fee is amortized on a “sum-of-the-months” accelerated basis over one year.

Netflix believes the use of an accelerated method is appropriate because we normally experience heavy initial demand for a title, which subsides once initial demand has been satisfied.

Cost of subscription revenues consists of revenue sharing costs, amortization of our DVD library, amortization of intangible assets related to equity investments issued to certain studios, and postage and packaging related to shipping titles to paying subscribers. Costs related to free trial subscribers are allocated to marketing expenses. Cost of DVD sales includes salvage value and revenue sharing costs for used DVDs sold.

The increase in cost of subscription revenues was attributable primarily to the following factors:

Number of DVDs mailed to paying subscribers increased 109.7% for the three months ended June 30, 2003, which was driven by a 76.4% increase in average paying subscribers coupled with an

18.8% increase in disc usage per average paying subscriber.
Number of DVDs mailed to paying subscribers increased 118.3%
for the six months ended June 30, 2003, which was driven by an
81.3% increase in average paying subscribers coupled with a
20.4% increase in disc usage per average paying subscriber.

Postage and packaging costs increased by $7.3 million and $14.1 million, representing a 109.4% and 117.1% increase, for the three and six months ended June 30, 2003, respectively. The increase was primarily a result of the increase in the number of DVDs mailed to paying subscribers.

Revenue sharing costs increased by $5.0 million and $9.6 representing a 72.9% and 72.6% increase, for the three and six months ended June 30, 2003, respectively. This increase was attributable primarily to the increase in average paying subscribers and the number of DVDs mailed to paying subscribers, partially offset by a modest decrease in the percentage of titles subject to revenue sharing agreements mailed to paying subscribers.

DVD amortization costs increased by $5.1 million and $8.7  million, representing a 141.5% and 143.7% increase, for the three and six months ended June 30, 2003, respectively. The increase was primarily related to increased acquisitions for our library during 2002 and the first half of 2003.

Amortization of intangibles remained mostly unchanged for the three and six months ended June 30, 2003 from the same prior-year periods.

Netflix anticipates cost of subscription revenues will increase in absolute dollars in the third quarter of 2003 as the number of average paying subscribers continues to grow.

Since inception, Netflix has financed their activities primarily through a series of private placements of convertible preferred stock, subordinated promissory notes, and our initial public offering in May 2002. As of June 30, 2003, Netflix had cash and cash equivalents of $71.2 million and short-term investments of $45.1 million. Although Netflix currently anticipate that the proceeds from our initial public offering, together with their available funds and cash flow from operations, will be sufficient to meet their cash needs for the foreseeable future, Netflix may require or elect to obtain additional financing. Their ability to obtain financing will depend on, among other things, their development efforts, business plans, operating performance, and condition of the capital markets at the time we seek financing. We cannot assure you that additional financing will be available to us on favorable terms when required, or at all. If Netflix raise additional funds through the issuance of equity, equity-linked or debt securities, those securities may have rights, preferences, or privileges senior to the rights of our common stock, and their stockholders may experience dilution.

For the six months ended June 30, 2003, net cash provided by operating activities increased 149.3% to $36.4 million from $14.6 million in the same prior-year period. This increase was attributable primarily to a net income of $0.9 million for the current six-month period as compared to a net loss of $15.8 million in the same prior-year period, a $9.1 million increase in amortization of their DVD library as a result of increased purchases during 2002 and the first half of 2003, and a $6.4 million change in operating assets and liabilities as a result of the overall increase in business volumes. The increase in net cash provided by operating activities was partially offset by a decrease of $11.2 million of non-cash interest expense in the current six-month period. This decrease was primarily attributable to a one-time interest expense of $10.7 million related to debt retirement incurred during the six months ended June 30, 2002.

For the six months ended June 30, 2003, net cash used in investing activities decreased 46.7% to $27.4 million from $51.4 million in the same prior-year period. This decrease was attributable primarily to $0.7 million of purchases of short-term investments in the current six-month period as compared to $42.1 million of purchases with a portion of the proceeds from their initial public offering in the same prior-year period. The decrease was partially offset by a $15.9 million increase in acquisitions of property and equipment and DVDs to support our growing business during the six months ended June 30, 2003.

For the six months ended June 30, 2003, net cash provided by financing activities decreased 96.6% to $2.4 million from $70.4 million in the same prior-year period. This decrease was attributable to $3.0 million of proceeds generated from the issuance of common stock in the current six-month period as compared to $86.5 million of proceeds primarily from our initial public offering in the same prior-year period, offset by $0.7 million of repayment of notes payable and capital lease obligations in the current six-month period as compared to $16.1 million in the same prior-year period.

Conclusion

The primary objective of Netflix investment activities is to preserve principal, while at the same time maximizing income they receive from investments without significantly increased risk. Some of the securities they invest in may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. Netflix intends to maintain our portfolio of cash equivalents and short-term investments in a variety of securities. Their cash equivalents are generally invested in money market funds, which are not subject to market risk because the interest paid on such funds fluctuates with the prevailing interest rate.

References
Marshall, D., McManus, W., & Viele, D. (2004). Accounting:  What the Numbers Mean,

6/e. New York:  McGraw-Hill Customer Publishing.

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