TRANSITION TO REALITY

Over the coming decades and across the world, Internet TV will replace linear TV. Apps will replace channels, remote controls will disappear, and screens will proliferate. As Internet TV grows from millions to billions, Netflix is leading the way. Linear TV is popular, but ripe for replacement People love TV content, and watch over a billion hours a day of linear TV. But people don’t love the linear TV experience, where channels present programs at particular times on non-portable screens with complicated remote controls. Consumers have to navigate through a grid, or use DVRs which add an on-demand layer at the cost of storage and complexity. Finding good things to watch isn't easy or enjoyable. While hugely popular, the linear TV channel model is ripe for replacement. The evolution to Internet TV apps is already starting The world’s leading linear TV networks, such as HBO, ESPN and BBC, are moving into Internet TV. The ESPN app runs on many Internet platforms and is specifically designed to showcase sports, both real-time and catch up. ESPN will keep improving its app to try to stay ahead of MLB, which offers another terrific Internet TV sports app. HBO’s app makes its films and series more accessible than on HBO’s linear channel. The BBC app in the UK provides a rich and popular on-demand interface for a wide range of BBC programming. The other major linear networks are not far behind. Internet TV is better than linear TV in ways consumers care about. While Internet TV is only a small percentage of video viewing today, it will keep growing because: The Internet is getting faster, more reliable and more available; Smart TV sales are increasing and eventually every TV will have Wi-Fi and apps; Smart TV adapters are getting better and cheaper; Tablet and smartphone viewing is increasing; Internet TV apps are improving through competition and frequent updates; Streaming will be the leading source for 4k Ultra-HD video; Internet video advertising is becoming more personalized and relevant; TV Everywhere provides an economic transition for existing networks; and New entrants like Netflix are innovating rapidly and driving improvements. Eventually, as linear TV is viewed less, the spectrum it now uses on cable, fiber, and over-the-air will be reallocated to expand Internet data transmission. Satellite TV subscribers will be fewer and more rural. The value of high-speed Internet will increase. This transformation is occurring at different speeds in different nations. In the UK, for example, the BBC is already starting to program for its iPlayer app as well as its linear channels, under-lining the large and growing viewership on iPlayer. In most countries, the conversion to 4k video will be led by Internet video because Internet services can efficiently serve just the homes with 4k televisions, while linear will have to convert entire markets channel by channel. For most existing networks, this economic transition to Internet TV will occur through TV Everywhere. If a consumer continues to subscribe to linear TV from a multi-channel video program distributor (MVPD), he/she will get a password to use the Internet apps for the networks to which he/she subscribes on linear TV. The more networks successfully keep their prime-time programming behind this authentication wall, the less “cord cutting” will occur. The same consumer who today finds it worthwhile to pay for a linear TV package will likely pay for a “linear plus apps” package. Existing linear networks that offer compelling apps will get more viewing and be more valuable. Those that fail to develop first-class apps will lose viewing and revenue. In addition to specific linear networks building apps, some large MVPDs will offer their own multi-channel app. Examples are Xfinity, Sky Go, and Horizon. So far, the individual network apps are ahead of the MVPD apps because consumers relate to the network brands, and the apps are tailored to the specific type of content (sports, reality, news, entertainment, etc.). In addition to creating opportunity for linear networks, the emergence of Internet TV enables new apps like Netflix, YouTube, Hulu, MLB.tv, and iTunes to build large-scale direct-to-consumer services that are independent of the existing MVPD bundle. Netflix singular focus Netflix is an increasingly global internet TV network offering movies and TV shows commercial-free, with unlimited viewing on any internet-connected screen for an affordable no-commitment monthly fee. We don’t and can’t compete on breadth of entertainment with Comcast, Sky, Amazon, Apple, Microsoft, Sony, or Google. For us to be hugely successful we have to be a focused passion brand. Starbucks, not 7-Eleven. Southwest, not United. HBO, not Dish. We don’t do pay-per-view or ad-supported content. Those are fine business models that other firms do well. We are about flat fee unlimited viewing commercial-free. We are not a generic “video” company that streams all types of video such as news, user-generated, sports, porn, music video, or reality. We are a movie and TV series network. We are a relief from the complexity and frustration that embody most MVPD relationships with their customers. We strive to be extremely straightforward. There is no better example of this than our no-hassle online cancellation. Members can leave when they want and come back when they want. We are about the freedom of on-demand and the fun of indulgent viewing. We are about the flexibility of any screen any time. We are about fantastic content that is only available on Netflix. We’ll spend in 2014 over $500M in marketing to attract people around the world to try Netflix, and to reinforce with our members why Netflix is worthy. Our extensive exclusive content is key, as is the ability for members to have control over their viewing experience. Winning more moments of truth We strive to win more of our members’ “moments of truth”. Those decision points are, say, at 7:15 pm when a member wants to relax, enjoy a shared experience with friends and family, or is just bored. They could play a video game, surf the web, read a magazine, channel surf their MVPD/DVR system, buy a pay-per-view movie, put on a DVD, turn on Hulu, or they could launch Netflix. We want our members to choose Netflix in these moments of truth. We win those moments of truth when members expect Netflix to be more pleasurable than their other options, based upon their prior experiences. The pleasure comes from easy choosing, total control over when to play/pause/resume a video, and content that suits the taste and mood of everyone in the household. We’ll invest in 2014 over $400M on technology development to continue to improve our service and our app on the very broad range of platforms we support. We put a lot of that emphasis on some core competencies: streaming delivery, sign-up, billing and customer service across more than 1000 devices being used in more than 40 countries. Here we strive for operational excellence. Members want Netflix to just work -- flawlessly. On this front, we’re well ahead, but have plenty of room to improve. We continue to invest heavily to ensure that our service is always available, our streaming never rebuffers, and our audio-video quality is pristine. Another area of focus is personalized recommendations and merchandising, which drives what content we feature on a member’s initial screen. Google search is an example of a ranking system, where results are automatically computed to show Google’s estimate of the most relevant answer to the query. For Netflix, the member’s opening screen is the personalized ranking of what we think will be most relevant content for that specific member selected from our diverse catalog. By analyzing terabytes of data from every recent click, view, repeat view, early abandon, page views and other data, we are able to generate a personalized display with the content most likely to please. Our aim is to keep inventing and tuning algorithms to generate higher satisfaction, viewing, and retention. As Google does in refining its search rankings, most of our algorithm work is proven or disproven by A/B testing. Only algorithms that lead to an improved experience get rolled out to everyone. There are numerous other areas we also are improving, such as how smoothly our scrolling works on an iPad, or how well our kids section works on a PS3. Most of this work is guided by A/B testing as well. The core metrics we use to evaluate A/B testing are signup rates, viewing, and retention. While our app is much better than it was 5 years ago, it will be even more incredible 5 years from now. Content people love We plan on spending nearly $3B in 2014 on content for our members. People’s tastes are very broad, even in a single market. The Internet allows us to offer a wide selection, and to have our user-interface quickly learn and make recommendations based upon each individual's tastes. Those members who love action blockbusters, Korean soaps, anime, sci-fi, Sundance films, zombie shows, or kids’ cartoons will find that Netflix fills their homepage with relevant and interesting titles. As we’ve gained experience, we’ve found that the 20th documentary about bicycling will mostly just take away viewing from the other 19 such docs, and instead of trying to have everything, we should strive to have the best in each category. As such, we are actively curating our service rather than carrying as many titles as we can. Our licensing is generally time-based, so that we might pay for a multi-year exclusive subscription video-on-demand (SVOD) license for a given title. At the time of renewal, we evaluate how much the title is getting viewed as well as member rating feedback to determine how much we are willing to pay. How many similar titles we have is also a consideration. In each market, we license content from multiple suppliers, mirroring the fragmentation of the content industry. Typically our bids are for exclusive access to the SVOD rights, and are against various cable and broadcast networks, as well as online competitors. As a rule, content owners always want another bidder, and never want one bidder to become too strong. Original content We’re now at the scale where we can economically create original content that debuts exclusively on Netflix. We’ll continue to grow our original content offering as we gain scale and confidence. With each original, we learn more about what our members want, about how to produce and promote effectively, and about the positive impact of originals on our brand. We believe we have a major advantage over our linear competitors when it comes to launching a show. The networks need to attract an audience on a given night at a given time. We can be much more flexible. Because each show on Netflix is not competing for scarce prime-time slots like on linear TV, a show that is taking a long time to find its audience is one we can keep nurturing. This allows us to prudently commit to a whole season, rather than just a pilot episode. In addition, we are able to provide a platform for more creative storytelling (varying run times per episode based on storyline, no need for week to week recaps, no fixed notion of what constitutes a “season”). We believe this makes it easier for us to attract creative talent. By personalizing promotion of the right content to the right member, we have a large opportunity to promote our original content and one that’s effectively unlimited in duration. Many months after the premiere of House of Cards, large numbers of members are just starting the series each week. The improved economics from full season, and the improved storytelling that comes from giving creators more scope, are big advantages for Netflix. The one material difference worth noting is original content production is cash-intensive and that means for us that cash is front loaded relative to the P&L. The expansion of original content will consume cash. Since we are otherwise using domestic profits to fund international markets, we will raise capital as needed to fund the growth of original content. We’ve had a great start with our initial set of original series. Any linear network would be proud to show them. Our success is due in part to great creative execution by our team as well as the power of our large on-demand platform. We’ll steadily grow our original content spending, and pace ourselves so that we have a high percentage of hits and stay efficient in terms of what we spend relative to licensed content. International The market structure for licensing movies and TV series is generally national, or, in some cases, a multinational region like the Nordics. We work within that distribution architecture, licensing our content for each market at prevailing prices. Each market has a mix of local and global content tastes. We assess them from a variety of information sources before we enter a market, and then after launch we learn more about what is most popular and what is not. As we smartly add and renew deals, the content mix improves. When we enter a market, we have to win the bidding for a substantial offering of content, and then market ourselves effectively to start the membership growth. It is an expensive process, but we believe any future competitor will have the same or larger challenges. Our advantages internationally are that our global technology investment is creating a superior app and service, our process knowledge, our data from related markets, and our globally-known brand. We strive to meet local tastes, but our disadvantage is not knowing each specific culture as well as local competitors. Our strategy is to expand as quickly as possible while staying profitable on a global basis, as long as there are compelling markets to expand into, and we are continuing to see growth in our current markets. Economic power comes from market-specific scale. We would be stronger being the leader in a few markets than one of the herd in many markets. Of course, our ambition is to be the leader in many markets, but that will take us some time. Competition We compete very broadly for a share of members’ time and spending, against linear networks, pay-per-view content, DVD watching, other internet networks, video games, web browsing, magazine reading, video piracy, and much more. Over the coming years, most of these forms of entertainment will improve. Linear networks have mostly exclusive content against each other, and this is increasingly true for Internet networks. Piracy and pay-per-view are the only two competitors that offer a nearly full set of TV show and movie content. We call competitors for entertainment time and spending “competitors-for-time”. We call the narrower set of firms that do bid against us for content “competitors-for-content”. The network that we think is likely to be our biggest long-term competitor-for-content is HBO. In the USA for example, HBO recently won long-term exclusive domestic movie output deals with Universal and Fox. HBO bids against us on many original content projects though is not currently a bidder against us for prior-season television from other networks. HBO has global reach and a strengthening technology capacity. In addition to HBO, there are Amazon/Lovefilm/Prime in the USA and UK, Hulu in the USA, Now TV in the UK, Viaplay in the Nordics, Clarovideo in Latin America, and many cable and broadcast networks in various territories. Amazon and Hulu are spending heavily and commissioning their own original programming, presumably because they see the same exciting big picture for Internet TV that we do. Many consumers will subscribe to multiple services if they each have unique compelling content. Success relative to these competitors-for-content would mean us having substantially larger revenue and therefore sustainably increasing content, tech and marketing spending, leading to further growth, and a virtuous cycle. In the USA, MVPDs have remained stable at about 100M subscribers while Netflix has grown to over 33M members. The stability of the MVPD subscriber base, despite Netflix’s large membership, suggests that most members consider Netflix complementary to, rather than a substitute for, MVPD video. ISP relationships We have productive relationships with most ISPs, given our joint interest in making broadband work well for people. The more successful Netflix becomes, the more important we are to the ISPs’ subscribers. Our Open Connect program allows ISPs to directly interconnect with the Netflix network for free, which results in higher video quality and reduced buffering interruptions for our joint subscribers. Nearly all ISPs in our markets outside the USA have joined Open Connect, and many in the USA have joined. It is natural for ISPs to worry that we may try to charge them in the future like linear TV networks charge MVPDs (ESPN3.com charged ISPs, for example). Broadband is quite profitable for ISPs partially because they don’t pay content costs, unlike MVPDs. We conversely worry that ISPs may try to charge us for supplying the video data their broadband subscribers are requesting. The danger for either side is a negative precedent that leads to an ever expanding charge under threat of blackouts. Long-term stability is achieved when neither side charges each other for the interconnection necessary to both sides for pleasing consumers. Open Connect is free to ISPs, and we bring the data at our expense to wherever the ISP wants. Unfortunately, Verizon successfully challenged the U.S. net neutrality rules. In principle, a domestic ISP now can legally impede the video streams that members request from Netflix, degrading the experience we jointly provide. The motivation could be to get Netflix to pay fees to stop this degradation. Were this draconian scenario to unfold with some ISP, we would vigorously protest and encourage our members to demand the open Internet they are paying their ISP to deliver. The most likely case, however, is that ISPs will avoid this consumer-unfriendly path of discrimination. ISPs are generally aware of the broad public support for net neutrality and don’t want to galvanize government action. Moreover, ISPs have very profitable broadband businesses they want to expand. Consumers purchase higher bandwidth packages mostly for one reason: high-quality streaming video. ISPs appear to recognize this and many of them are working closely with us and other streaming video services to enable the ISPs subscribers to more consistently get the high-quality streaming video that consumers desire. In the long-term, we think Netflix and consumers are best served by strong network neutrality across all networks, including wireless. To the degree that ISPs adhere to a meaningful voluntary code of conduct, less regulation is warranted. To the degree that some aggressive ISPs start impeding specific data flows, more regulation would be clearly needed. Netflix margin structure and growth Our domestic margin structure is mostly set top down. For any given future period, we estimate revenue, and decide what we want to spend, and how much margin we want in that period. Competitive pressures in bidding for content would lead us to have slightly less content than we would otherwise, rather than overspending. The same is true for our marketing budget. The output variable is membership growth that those spending choices influence. The margin structure we have chosen is to grow content spending plus marketing slightly more slowly than we grow revenue, and in the USA to target for now about 400 basis points of contribution margin improvement compared to same quarter of the prior year. A 30% quarterly contribution margin may start being achievable in 2015. At 30%, we’ll re-evaluate the right margin growth target, given conditions at that time. To the extent our contribution margin climbs above 30%, it will get harder to keep it growing at 400 basis points per year. The primary forces propelling our growth are our own service, content and marketing improvements, and the improvement of Internet networks and devices. The primary forces impeding our growth are market saturation and the broad set of competitors-for-time all improving their offerings. At a high-level, HBO-linear is our closest domestic comparison, with about 30 million domestic members. We currently have fewer original series and first window (“Pay1”) movies than HBO, but we have more content, more viewing per member, a broader brand proposition, are on-demand, on all devices, and are less expensive. We estimate that we can be 2 to 3 times larger than current linear-HBO, or 60-90 million domestic members. This estimate factors in that, as we grow, our content and service will continue to get better. Longevity & defensibility of profit stream One of the reasons we are investing so heavily in international expansion is we believe that once a subscription video service has achieved profitability and scale in a market (20% to 30% of households), it is very likely to be able to sustain that profit stream for many decades. Conclusion If we could look into the future at the ways that people access entertainment, we would no doubt see a very different image than we see today - stunning video quality, a proliferation of screens, yet-unimagined natural user interface, and an unbelievable range of choice. But if we were to turn instead and look at the person watching that screen, we’d observe a number of similarities across generations. We'd see someone who is taking a moment to escape into a story - to simply relax and enjoy one of life's real pleasures with their friends and family. People love TV shows & movies. We love being the best possible place to enjoy them. Ours is an amazing opportunity to grow, innovate and lead for several decades. We will face strong competition along the way, and we embrace the challenge.