Overview

Our Business

With more than 10 million subscribers, we are the largest online movie rental subscription service in the United States. We offer a variety of subscription plans, with no due dates, no late fees, no shipping fees and no pay-per-view fees. We provide subscribers access to over 100,000 DVD and Blu-ray titles plus more than 12,000 streaming content choices. Subscribers select titles at our Web site aided by our proprietary recommendation service and merchandising tools. Subscribers can:

• Receive DVDs by U.S. mail and return them to us at their convenience using our prepaid mailers. After a DVD has been returned, we mail the next available DVD in a subscriber's queue.

• Watch streaming content without commercial interruption on personal computers ("PCs"), Intel-based Macintosh computers ("Macs") and televisions ("TVs"). The viewing experience is enabled by Netflix controlled software that can run on a variety of devices. These devices include PCs, Macs, Internet connected Blu-ray players, such as those manufactured by LG Electronics and Samsung, set-top boxes, such as TiVo and the Netflix Player by Roku, game consoles, such as Microsoft's Xbox 360, and planned for later this year, TVs from Vizio and LG Electronics.

Our core strategy is to grow a large subscription business consisting of DVD by mail and streaming content. We offer over 100,000 titles on DVD. In comparison, the 12,000 content choices available for streaming are relatively limited. We expect to substantially broaden the content choices as more content becomes available to us. Until such time, by bundling DVD and streaming as part of the Netflix subscription, we are able to offer subscribers a uniquely comprehensive selection of movies for one low monthly price. We believe this creates a competitive advantage as compared to a streaming only subscription service. This advantage will diminish over time as more content becomes available over the Internet from competing services, by which time we expect to have further developed our other advantages such as brand, distribution, and our proprietary merchandising platform. Despite the growing popularity of Internet delivered content, we expect that DVD will continue to be the primary means by which most Netflix subscribers view content for the foreseeable future. However, at some point in the future, we expect that Internet delivery of content directly to the home will surpass DVD.

Key Business Metrics

Management periodically reviews certain key business metrics within the context of our articulated performance goals in order to evaluate the effectiveness of our operational strategies, allocate resources and maximize the financial performance of our business. The key business metrics include the following:

• Churn: Churn is a monthly measure defined as customer cancellations in the quarter divided by the sum of beginning subscribers and gross subscriber additions, then divided by three months. Management reviews this metric to evaluate whether we are retaining our existing subscribers in accordance with our business plans.

• Subscriber Acquisition Cost: Subscriber acquisition cost is defined as total marketing expense divided by total gross subscriber additions. Management reviews this metric to evaluate how effective our marketing programs are in acquiring new subscribers on an economical basis in the context of estimated subscriber lifetime value.

• Gross Margin: Management reviews gross margin to monitor variable costs and operating efficiency.

Management believes it is useful to monitor these metrics together and not individually as it does not make business decisions based upon any single metric. Please see "Results of Operations" below for further discussion on these key business metrics.

Performance Highlights

The following represents our performance highlights for 2008, 2007 and 2006 (in
thousands, except for per share amounts, percentages and subscriber acquisition
costs):



                                              2008            2007           2006
      Revenues                             $ 1,364,661     $ 1,205,340     $ 996,660
      Net income                                83,026          66,608        48,839
      Net income per share-diluted         $      1.32     $      0.97     $    0.71

      Total subscribers at end of period         9,390           7,479         6,316

      Churn (annualized) (1)                       4.2 %           4.3 %         4.1 %
      Subscriber acquisition cost          $     29.12     $     40.86     $   42.94
      Gross margin                                33.3 %          34.8 %        37.1 %

(1) Churn (annualized) is the average of Churn for the four quarters of each respective year

Recent Developments

We continue to broaden the content available for streaming including recent additions of content from CBS, Disney, Sony and Starz Play. We have also announced several partnerships with technology and consumer electronics companies that enable our subscribers to watch streaming content without commercial interruption. These partners include Roku, LG Electronics, Microsoft, Samsung, TiVo and Vizio.

Critical Accounting Policies and Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reported periods. The Securities and Exchange Commission ("SEC") has defined a company's critical accounting policies as the ones that are most important to the portrayal of a company's financial condition and results of operations, and which require a company to make its most difficult and subjective judgments. Based on this definition, we have identified the critical accounting policies and judgments addressed below. We base our estimates on historical experience and on various other assumptions that the Company believes to be reasonable under the circumstances. Actual results may differ from these estimates.

Content Accounting

We obtain content from studios and distributors through direct purchases, revenue sharing agreements or license agreements.

We acquire DVD content for the purpose of rental to our subscribers and earning subscription rental revenues, and, as such, we consider our DVD library to be a productive asset. Accordingly, we classify our DVD library as a non-current asset on our consolidated balance sheets. Additionally, in accordance with Statement of Financial Accounting Standards ("SFAS") No. 95, Statement of Cash Flows, ("SFAS 95") cash outflows for the acquisition of the DVD library, net of changes in related accounts payable, are classified as cash flows from investing activities on our consolidated statements of cash flows. This is inclusive of any upfront non-refundable payments required under revenue sharing agreements.

We amortize our DVDs, less estimated salvage value, on a "sum-of-the-months" accelerated basis over their estimated useful lives. The useful life of the new-release DVDs and back-catalog DVDs is estimated to be one year and three years, respectively. In estimating the useful life of our DVDs, we take into account library utilization as well as an estimate for lost or damaged DVDs.

For those direct purchase DVDs that we estimate we will sell at the end of their useful lives, a salvage value of $3.00 per DVD has been provided. For those DVDs that we do not expect to sell, no salvage value is provided. We periodically evaluate the useful lives and salvage values of our DVDs.

We also obtain content distribution rights in order to stream movies and TV episodes without commercial interruption to subscribers. We account for streaming content in accordance with SFAS No. 63, Reporting by Broadcasters ("SFAS 63"), which requires classification of streaming content as either a current or non-current asset in the consolidated balance sheets based on the estimated time of usage after certain criteria have been met, including availability of the streaming content for its first showing. We amortize our streaming content on a straight-line basis generally over the term of the related license agreements or the title's window of availability. Cash outflows associated with the streaming content are classified as cash flows from operating activities on our consolidated statements of cash flows.

We also obtain DVD and streaming content through revenue sharing agreements with studios and distributors. We generally obtain titles for low initial cost in exchange for a commitment to share a percentage of our subscription revenues or a fee, based on utilization, over a fixed period, or the Title Term, which typically ranges from six to twelve months for each title. The initial cost may be in the form of an upfront non-refundable payment. This payment is capitalized in the content library in accordance with our DVD and streaming content policies as applicable. The initial cost may also be in the form of a prepayment of future revenue sharing obligations which is classified as prepaid revenue sharing expense. The terms of some revenue sharing agreements with studios obligate us to make minimum revenue sharing payments for certain titles. We amortize minimum revenue sharing prepayments (or accrete an amount payable to studios if the payment is due in arrears) as revenue sharing obligations are incurred. A provision for estimated shortfall, if any, on minimum revenue sharing payments is made in the period in which the shortfall becomes probable and can be reasonably estimated. Under the revenue sharing agreements for our DVD library, at the end of the Title Term, we generally have the option of returning the DVD to the studio, destroying the DVD or purchasing the DVD.

Additionally, the terms of certain DVD direct purchase agreements with studios provide for volume purchase discounts or rebates based on achieving specified performance levels. Volume purchase discounts are recorded as a reduction of DVD library when earned. We accrue for rebates as earned based on historical title performance and estimates of demand for the titles over the remainder of the title term.

Stock-Based Compensation

We adopted the provisions of SFAS No. 123(R), Share-Based Payment ("SFAS 123R"), on January 1, 2006. Under the fair value recognition provisions of this statement, stock-based compensation cost is estimated at the grant date based on the fair value of the awards expected to vest and is recognized as expense ratably over the requisite service period, which is the vesting period.

We changed our method of calculating the fair value of new stock-based compensation awards under our stock plans from a Black-Scholes model to a lattice-binomial model on January 1, 2007. We continue to use a Black-Scholes option model to determine the fair value of employee stock purchase plan shares. The lattice-binomial model has been applied prospectively to options granted subsequent to January 1, 2007. The lattice-binomial model requires the input of highly subjective assumptions, including the option's price volatility of the underlying stock. Changes in the subjective input assumptions can materially affect the estimate of fair value of options granted and our results of operations could be materially impacted.

• Expected Volatility: Our computation of expected volatility is based on a blend of historical volatility of our common stock and implied volatility of tradable forward call options to purchase shares of our common stock. Our decision to incorporate implied volatility was based on our assessment that implied volatility of publicly traded options in our common stock is more reflective of market conditions and, therefore, can reasonably be expected to be a better indicator of expected volatility than historical volatility of our common stock.

We grant stock options to our employees on a monthly basis. We have elected to grant all options as non-qualified stock options which vest immediately. As a result of immediate vesting, stock-based compensation expense determined under SFAS No. 123(R) is fully recognized on the grant date and no estimate is required for post-vesting option forfeitures. See Note 7 to the consolidated financial statements for further information regarding SFAS No. 123(R).

Income Taxes

We record a tax provision for the anticipated tax consequences of our reported results of operations using the asset and liability method. Deferred income taxes are recognized by applying the enacted tax rates applicable to future years to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by a valuation allowance for any tax benefits for which future realization is uncertain.

As of December 31, 2008, our deferred tax asset balance was $28.0 million. As of December 31, 2007, our deferred tax asset balance was $19.1 million. There was no valuation allowance as of December 31, 2008 or 2007.

During 2007, we adopted the Financial Accounting Standard Board's ("FASB") Financial Interpretation No. ("FIN") 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 ("FIN 48"). FIN 48 changes the accounting for uncertainty in income taxes by creating a new framework for how companies should recognize, measure, present and disclose uncertain tax positions in their financial statements. Under FIN 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. We recognize interest and penalties related to uncertain tax positions in income tax expense. See Note 8 to the consolidated financial statements for further information regarding income taxes.

In evaluating our ability to recover our deferred tax assets, in full or in part, we consider all available positive and negative evidence, including our past operating results, and our forecast of future market growth, forecasted earnings, future taxable income and prudent and feasible tax planning strategies. The assumptions utilized in determining future taxable income require significant judgment and are consistent with the plans and estimates we are using to manage the underlying businesses. We believe that the deferred tax assets recorded on our balance sheet will ultimately be realized. In the event we were to determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to earnings in the period in which we make such determination.

Descriptions of Consolidated Statements of Operations Components

Revenues

We derive substantially all of our revenues from monthly subscription fees and recognize subscription revenues ratably over each subscriber's monthly subscription period. We record refunds to subscribers as a reduction of revenues. We generate all our revenues in the United States.

Cost of Revenues

Subscription

Cost of subscription revenues consists of postage and packaging costs related to shipping DVDs to subscribers as well as content related expenses. Costs related to free-trial periods are allocated to marketing expenses.

Postage and Packaging. Postage and packaging expenses consist of the postage costs to mail DVDs to and from our paying subscribers and the packaging and label costs for the mailers. Between January 8, 2006 and May 13, 2007, the rate for first-class postage was $0.39. The U.S. Postal Service increased the rate of first class postage by 2 cents to $0.41 effective May 14, 2007 and by one cent to $0.42 effective May 12, 2008. We receive discounts on outbound postage costs related to our mail preparation practices.

Content Expenses. We obtain titles from studios and distributors through direct purchases, revenue sharing agreements or license agreements. Direct purchases of DVDs normally result in higher upfront costs than titles obtained through revenue sharing agreements. Content related expenses consist of costs incurred in obtaining titles such as amortization of content and revenue sharing expense.

Fulfillment expenses

Fulfillment expenses represent those expenses incurred in operating and staffing our shipping and customer service centers, including costs attributable to receiving, inspecting and warehousing our content library. Fulfillment expenses also include credit card fees.

Operating Expenses

Technology and Development. Technology and development expenses consist of payroll and related costs incurred in testing, maintaining and modifying our Web site, our recommendation service, developing solutions for streaming content to subscribers, telecommunications systems and infrastructure and other internal-use software systems. Technology and development expenses also include depreciation of the computer hardware and capitalized software we use to run our Web site and store our data.

Marketing. Marketing expenses consist primarily of advertising expenses. Advertising expenses include marketing program expenditures and other promotional activities, including allocated costs of revenues relating to free trial periods Also included in marketing expense are payments made to our consumer electronics partners to generate new subscribers for our service as well as payroll related expenses.

General and Administrative. General and administrative expenses consist of payroll and related expenses for executive, finance, content acquisition and administrative personnel, as well as recruiting, professional fees and other general corporate expenses.

Stock-Based Compensation. Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R) using the modified prospective method.

We grant stock options to our employees on a monthly basis. We have elected to grant all options as non-qualified stock options which vest immediately. As a result of immediate vesting, stock-based compensation expense determined under SFAS No. 123(R) is fully recognized on the grant date, and no estimate is required for post-vesting option forfeitures.

Gain on disposal of DVDs. Gain on disposal of DVDs represents the difference between proceeds from sales of DVDs and associated cost of DVD sales. Cost of DVD sales includes the net book value of the DVDs sold, shipping charges and, where applicable, a contractually specified fee for the DVDs that are subject to revenue sharing agreements.

Results of Operations

The following table sets forth, for the periods presented, the line items in our consolidated statements of operations as a percentage of total revenues. The information contained in the table below should be read in conjunction with the financial statements and notes thereto included in Item 8, Financial Statements and Supplementary Data of this Annual Report on Form 10-K.

                                                         Year Ended December 31,
                                                       2008        2007       2006
    Revenues                                            100.0 %    100.0 %    100.0 %
    Costs of revenues:
    Subscription                                         55.8       55.1       53.4
    Fulfillment expenses                                 10.9       10.1        9.5

    Total cost of revenues                               66.7       65.2       62.9

    Gross profit                                         33.3       34.8       37.1

    Operating expenses:
    Technology and development                            6.6        5.9        4.8
    Marketing                                            14.6       18.1       22.6
    General and administrative                            3.6        4.3        3.6
    Gain on disposal of DVDs                             (0.4 )     (0.5 )     (0.5 )
    Gain on legal settlement                               -        (0.6 )       -

    Total operating expenses                             24.4       27.2       30.5

    Operating income                                      8.9        7.6        6.6
    Other income (expense):
    Interest expense on lease financing obligations      (0.2 )     (0.1 )     (0.1 )
    Interest and other income (expense)                   0.9        1.7        1.5

    Income before income taxes                            9.6        9.2        8.0
    Provision for income taxes                            3.5        3.7        3.1

    Net income                                            6.1 %      5.5 %      4.9 %

Revenues



                                                             Year Ended December 31,
                                           2008                         2007                       2006
                                              (in thousands, except percentages and average monthly
                                                   subscription revenue pre paying subscriber)
Revenues                            $        1,364,661          $         1,205,340          $         996,660
Percentage change over prior
period                                            13.2 %                       20.9 %

Other data:
Average number of paying
subscribers                                      8,268                        6,718                      5,083
Percentage change over prior
period                                            23.1 %                       32.2 %
Average monthly revenue per
paying subscriber                   $            13.75          $             14.95          $           16.34
Percentage change over prior
period                                            (8.0 )%                      (8.5 )%

The increase in our revenues in 2008 as compared to 2007, and 2007 as compared to 2006, was primarily a result of the substantial growth in the average number of paying subscribers arising from increased consumer awareness of the benefits of online movie and TV episode rentals and other aspects of our service. This increase was offset in part by a decline in average monthly revenue per paying subscriber, resulting from the continued growth in our lower cost subscription plans, as well as a price reduction for our most popular subscription plans during the third quarter of 2007. We expect the average revenue per paying subscriber to continue to decline until the mix of new subscribers and existing subscribers is approximately equivalent by subscription plan price point.

The following table presents our ending subscriber information:

                                                      As of December 31,
                                              2008             2007          2006
                                              (in thousands, except percentages)
    Free subscribers                              226              153          162
    As a percentage of total subscribers          2.4 %            2.0 %        2.6 %
    Paid subscribers                            9,164            7,326        6,154
    As a percentage of total subscribers         97.6 %           98.0 %       97.4 %
    Total subscribers                           9,390            7,479        6,316
    Percentage change over prior period          25.6 %           18.4 %


Cost of Revenues

Subscription



                                                    Year Ended December 31,
                                              2008              2007          2006
                                              (in thousands, except percentages)
    Subscription                          $    761,133       $  664,407     $ 532,621
    As a percentage of revenues                   55.8 %           55.1 %        53.4 %
    Percentage change over prior period           14.6 %           24.7 %

The increase in cost of subscription revenues in absolute dollars for 2008 as compared to 2007 was primarily attributable to the following factors:

• The number of DVDs mailed to paying subscribers increased 19%. This was driven by a 23% increase in the number of average paying subscribers, partially offset by a decline in monthly DVD rentals per average paying subscriber attributed to the continued growth of our lower priced plans.

• Postage and packaging expenses increased by 23%. This was primarily attributable to the increase in the number of DVDs mailed to paying subscribers and increases in the rates of first class postage in May 2007 and May 2008.

• Content expenses increased by 7%. This increase was primarily attributable to the increased investments in streaming content in 2008, as well as an increase in DVD revenue sharing costs.

The increase in cost of subscription revenues in absolute dollars for 2007 as compared to 2006 was primarily attributable to the following factors:

• The number of DVDs mailed to paying subscribers increased 20%. This was driven by a 32% increase in the number of average paying subscribers, partially offset by a decline in monthly movie rentals per average paying subscriber attributed to the continued growth of our lower priced plans.

• Postage and packaging expenses increased by 24%. This was primarily attributable to the increase in the number of DVDs mailed to paying subscribers, as well as an increase in the rate of first class postage of 2 cents in May 2007.

• Content expenses increased by 26%. This increase was primarily attributable to the increased acquisition of DVD library with the remaining increase attributable to the investment in streaming content as we introduced Internet delivery of content in January 2007.

Fulfillment Expenses



                                                    Year Ended December 31,
. . .