Question

The questions in this exercise are based on Netflix, Inc. To answer the questions you will need to download Netilix’s Form 10-K for the year ended December 31, 2005 at www.sec.gov/edgar!searchedgar/companysearch.html. Once at this website, input CIK code 1065280 and hit enter. In the gray box on the right-hand side of your computer screen define the scope of your search by inputting 10-K and then pressing enter. Select the 10-K with a filing date of March 16, 2006. You do not need to print this document to answer the questions.

 

Required:

1. What is Netilix’s strategy for success in the marketplace? Does the company rely primarily on a customer intimacy, operational excellence, or product leadership customer value proposition? What evidence supports your conclusion?
2. What business risks does Netflix face that may threaten the company’s ability to satisfy stockholder expectations? Of the risks that you have identified, which ones are controllable and which ones are largely uncontrollable?
3. Prepare a comparative balance sheet
    similar to the one shown in Exhibit 15—4 (Use Netilix’s data from 2004 and 2005). For each account shown on Netilix’s balance sheet,
    calculate the change in the balance and whether the change represents a source or a use of cash.
4. Explain how each change shown in your comparative balance sheet is accounted for in Netflix’s 2005 statement of cash flows.

Answer 1

1.   Netflix mentions four competitive strengths on page 3 of its 10-K: comprehensive library of titles, personalized merchandising, scalable business model, and convenience, selection and fast delivery. These strengths suggest that Netflix’s strategy relies on a combination of customer intimacy and operational excellence. Netflix is attempting to create customer intimacy by using proprietary personalized merchandising software to tailor a comprehensive library of 55,000 titles to the unique viewing interests of individual customers. The company’s operational excellence value proposition is a function of providing customers with convenient internet-based access to and fast delivery of a large selection of DVD movies. It is also a function of the company’s scalable business model. In other words, Netflix’s internet-based business model allows it to increase sales without the need to build and staff costly retail outlets.

 

      While students can make defensible arguments in favor of either value proposition, most internet companies attract customers by offering convenient order placement and delivery of products such as books, DVDs, airline tickets, etc. at low prices. Although these companies seek to increase sales by using software that tailors their offerings to individual customer preferences, the bedrock of their success hinges on operational excellence.

 2.   Netflix faces numerous business risks as described on pages 8-20 of the annual report. Students may appropriately contend that many of these risks call into question the viability of Netflix’s strategy. Here are four risks faced by Netflix. Two of these risks are largely uncontrollable and two have suggested control activities:

 

• Risk: Video on Demand (VOD) technology, which enables cable and internet providers to immediately transmit movies to customers on demand, may supplant the Netflix business model. Netflix customers cannot get immediate access to the movies they wish to watch because they have to wait until they arrive by mail. Netflix does not have a readily available control activity to reduce this risk, which continues to grow as the quality and speed of VOD content delivery improves.
• Risk: Studios will alter their filmed entertainment release date practices in a manner that threatens Netflix’s sales. Page 10 of the 10-K says “DVDs currently enjoy a significant competitive advantage over other distribution channels, such as pay-per-view and VOD, because of the early distribution window for DVDs…. Currently, studios distribute their filmed entertainment content approximately three to six months after theatrical release to the home video market, seven to nine months after theatrical release to pay-per-view and VOD, one year after theatrical release to satellite and cable, and two to three years after theatrical release to basic cable and syndicated networks.” If movie studios choose to shrink or close the window of time that companies such as Netflix can rent new DVD releases without competition from competing mediums (such as pay-per-view and VOD), it will lower retailers’ DVD rental revenues. Netflix does not have a readily available control activity to reduce this risk.

 

• Risk: Computer viruses could disrupt Netflix’s website. In addition, computer hackers could obtain unauthorized accessed to customers’ credit card numbers. Either event would damage the company’s reputation and sales growth goals. Control activities: Invest generously in firewalls and encryption technology to keep website and sensitive customer information secure.

 

• Risk: Inaccurate forecasts may lead to excessive inventory of some movie titles and stockouts of other titles. Control activities: Create software that allows users to rate movies that they have viewed. The customer feedback helps predict what movie titles will thrive or dive.

 

3.   The comparative balance sheet is shown below and on the following page:

Netflix, Inc. Comparative Balance Sheet (in thousands)
	Beginning  Balance	Ending  Balance	Change	Source Or Use?
Assets
Current assets:
Cash and cash equivalents	$174,461	$212,256	+37,795
Prepaid expenses	2,741	7,848	+5,107	Use
Prepaid revenue sharing expenses	4,695	5,252	+557	Use
Deferred tax assets	0	13,666	+13,666	Use
Other current assets	5,449	4,669	−780	Source
Total current assets	187,346	243,691
DVD library, net	42,158	57,032	+14,874	Use
Intangible assets, net	961	457	−504	Source
Property and equipment, net	18,728	40,213	+21,485	Use
Deposits	1,600	1,249	−351	Source
Deferred tax assets	0	21,239	+21,239	Use
Other assets	1,000	800	−200	Source
Total assets	$251,793	$364,681

Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$ 49,775	$ 63,491	+13,716	Source
Accrued expenses	13,131	25,563	+12,432	Source
Deferred revenue	31,936	48,533	+16,597	Source
Current portion of capital leases	68	0	−68	Use
Total current liabilities	94,910	137,587
Deferred rent	600	842	+242	Source
Total liabilities	95,510	138,429
Stockholders’ Equity:
Common stock	53	55	+2	Source
Additional paid-in capital	292,843	317,194	+24,351	Source
Deferred stock-based compensation	(4,693)	(1,326)	+3,367	Source
Accumulated other comp. income	(222)	0	+222	Source
Accumulated deficit	(131,698)	(89,671)	+42,027	Source
Total stockholders’ equity	156,283	226,252
Total liabilities and stockholders’ equity	$251,793	$364,681

 

4.   The changes shown on the balance sheet are accounted for on the statement of cash flows as follows (all amounts are in thousands):

 

•    The change in the Cash and Cash Equivalents of $37,795 is shown on the statement of cash flows as the Net Increase in Cash and Cash Equivalents.

 

•    The changes in Prepaid Expenses, Prepaid Revenue Sharing Expenses, and Other Current Assets are accounted for in the operating activities section of the statement of cash flows under Changes in Prepaid Expenses and Other Current Assets. The reconciliation is as follows:

 

Balance Sheet:
Prepaid expenses (Use)	$(5,107)
Prepaid revenue sharing expenses (Use)	(557)
Other current assets (Source)	780
Use of cash	$(4,884)
Statement of Cash Flows:
Change in prepaid expenses and other current assets (Use)	$(4,884)

 

•    The changes in Deferred Tax Assets in the current and noncurrent asset sections of the balance sheet are accounted for in the operating activities section of the statement of cash flows under Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities. The reconciliation is as follows:

Balance Sheet:
Deferred tax assets x current (Use)	$(13,666)
Deferred tax assets x noncurrent (Use)	(21,239)
Use of cash	$(34,905)
Statement of Cash Flows:
Adjustments to net income x Deferred taxes (Use)	$(34,905)

 

 

•    The change in the DVD Library, Net account on the balance sheet is accounted for in the operating and investing activities sections of the statement of cash flows. The reconciliation is as follows:

 

Balance Sheet:
DVD library, net (Use)	$(14,874)
Statement of Cash Flows:
Adjustment to net income x amortization of DVD library (Source)	$96,883
Adjustment to net income x gain on disposal of DVDs (Use)	(3,588)
Acquisitions of DVD library (Use)	(113,950)
Proceeds from sale of DVDs (Source)	5,781
Use of cash	$(14,874)

 

•    The change in the Intangible Assets, Net account on the balance sheet is accounted for in the operating and investing activities sections of the statement of cash flows. The reconciliation is as follows:

 

Balance Sheet:
Intangible assets, net (Source)	$504
Statement of Cash Flows:
Adjustments to net income x amortization of intangible assets (Source)	$985
Acquisition of intangible asset (Use)	(481)
Source of cash	$504

 

•    The change in the Property and Equipment, Net account on the balance sheet is accounted for in the operating and investing activities sections of the statement of cash flows. The reconciliation is as follows:

 

 

Balance Sheet:
Property and equipment, net (Use)	$(21,485)
Statement of Cash Flows:
Adjustments to net income x depreciation of property and equipment (Source)	$   9,134
Purchases of property and equipment (Use)	(30,619)
Use of cash	$(21,485)

•    The changes in the Deposits and Other Assets balance sheet accounts are accounted for in the investing activities section of the statement of cash flows. The reconciliation is as follows:

Balance Sheet:
Deposits (Source)	$351
Other assets (Source)	200
Source of cash	$551
Statement of Cash Flows:
Deposits and other assets	$551

•    The changes in the Accounts Payable ($13,716), Accrued Expenses ($12,432), Deferred Revenue ($16,597), and Deferred Rent ($242) balance sheet accounts are directly recorded in the operating activities section of the statement of cash flows.
•    The change in the Current Portion of Capital Leases account on the balance sheet is accounted for in the operating and financing activities sections of the balance sheet. The reconciliation is as follows:

 

Balance Sheet:
Current portion of capital leases (Use)	$(68)
Statement of Cash Flows:
Adjustments to net income x non-cash interest expense (Source)	$11
Principal payments on notes payable and capital lease obligations (Use)	(79)
Use of cash	$68

 

•    The Common Stock, Additional Paid-In Capital, and Deferred Stock-Based Compensation balance sheet accounts are recorded in the operating and financing activities sections of the statement of cash flows. The reconciliation is as follows:

Balance Sheet:
Common stock (Source)	$        2
Additional paid-in capital (Source)	24,351
Deferred stock-based compensation (Source)	3,367
Source of cash	$27,720
Statement of Cash Flows:
Adjustments to net income x stock-based compensation expense (Source)	$14,327
Proceeds from issuance of commons stock (Source)	13,393
Source of cash	$27,720

 

•   

The change in the Accumulated Other Comprehensive Income balance sheet account ($222) is directly accounted for in the financing activities section of the statement of cash flows. The change in the Accumulated Deficit balance sheet account ($42,027) corresponds with the net income reported in the statement of cash flows.