Accounting Analysis

Netflix, Inc. appears to be very forthcoming in their 10-K report for the fiscal year ending
on December 31, 2005. As a firm that was only launched in 1999, they have successfully
distinguished themselves from a broad array of competitors. During this period of rapid
growth, they have made positive strides in identifying their competition and numerous
risk factors. The firm has also made some adjustments to their accounting practices over
the same period. Our analysis of Netflix, Inc. must consider all of these different aspects
when interpreting their financial statements.

Competition
We have chosen to focus on Blockbuster, Inc. and Movie Gallery, Inc. as the two largest
direct competitors of Netflix, Inc. However, the 10-K report provides a much more
comprehensive list of competitive forces. In addition to the two video rental outlets
mentioned, the firm also claims to compete with movie retail stores, online DVD
subscription rental sites, pay-per-view channels, cable television, satellite television, and
the internet. This shows that the firm is aware of competition from all potential rivals.

Blockbuster, Inc. and Movie Gallery, Inc. are the most established market leaders for
DVD rentals. Their business models differ dramatically from Netflix, Inc. because they
rely on video outlet stores and not simply the internet. Several accounting practices
differ between the three firms because of these different business models. For example,
………

Risk Factors
The firm clearly states many factors that pose a risk to future success. Thirty-four of
these factors are related to risks to the business, while five additional factors address risks
to stock ownership. Many of the risk factors have an impact on three key business
metrics defined by the firm. These metrics are churn, subscriber acquisition cost, and
gross margin. Churn is a quarterly measure of cancelled subscriptions versus existing
and added subscriptions. Subscriber acquisition cost is the marketing cost per new
subscriber. These two metrics can be negatively impacted by the market response of
major competitors. Gross margin is a final metric that allows management to monitor
costs with the aim of improving overall operating efficiency.

Reclassification –Gain on Disposal of DVD’s

The Consolidated Statements of Income prior to 2005 reported the proceeds from sales
and associated costs of previously viewed DVD’s as Sales Revenues and Cost of Sales
Revenues, respectively. After discussions with the SEC in 2005, the firm began to report
the net gain on sales of DVD’s as a separate line item within Operating Income. The
Consolidated Statements of Income for 2003 and 2004 were reclassified to conform to
the 2005 presentation. This corrected presentation is consisted with the practices of
Blockbuster, Inc. and Movie Gallery, Inc. It addresses the way the firm accounts for the
impairment or disposal of long-lived assets. The reclassification has no effect on Net
Income, but shows the firm’s willingness to make subtle adjustments to its accounting
practices as the business continues to expand.
Reclassification – Fulfillment Expenses
Fulfillment expenses were previously reported as part of Operating Expenses. Further
discussions with the SEC in 2005 led the firm to reclassify these expenses as part of Cost
of Revenues on the Consolidated Statements of Income. Statements for 2003 and 2004
were also reclassified accordingly. This reclassification increases the Cost of Revenues,
thereby decreasing Gross Profit and Operating Expenses. It does not, however, affect
Operating Income, Net Income, Working Capital, or Cash from Operations. This is
another example of a refined adjustment to the firm’s accounting practices over time.

Material Weakness – Accounting for Income Taxes

Movie Gallery

Diverse business model with 2 focused lines of business: Store based movie rental in
large and small cities and Games. Each of the 3 companies, Movie Gallery, Hollywood
and Game Crazy, target a specific audience without any overlap. Movie accounted for
83% of revenues and games accounted for the remaining.

Competition
With their store-based operating model, they see Blockbuster as the principal competitor.
The company claims to compete with movie retail stores, online DVD subscription rental
sites, cable television, satellite television, and small town/small business movie rental
stores. These stores compete with Movie Gallery which operates in small and non-urban
towns.

The company seems to be aware of competition from all potential rivals. Online movie
rental companies like Netflix and Blockbuster Online are also perceived as potentially
significant competitors.

But, with all these perceived competition, they don’t seem to have total control to counter
any competition. This is because of their financing model which will be explained
subsequently in risk factors.

Risk Factors

High indebtedness stated as a major risk which may impair their future funding prospects
and accounts payable obligations. They have around $1.16 billion worth of indebtedness
which is due by 2012. They have stated refinancing and selling assets as risk mitigation
options.

The substantial credit obtained under the senior credit program is quite restrictive. It
imposes lot of restrictions on new business ventures, use proceeds of asset sales etc.
Compliance with the senior credit and financial covenants terms is an important factor in
future funds and assets management. This will restrict MG from reacting to new business
ideas of competitors.

Risks are detailed clearly and elaborately.

Complete integration of management and processes with Hollywood Video is also

perceived as a risk. This is because, that acquisition has been Movie Gallery’s biggest
and poses tedious integration tasks. This could also increase their operating costs.

Financials:

Assets:
Made small acquisitions which are not significant from a operating results stand point.

The fair value of the accounting units was lesser than the carrying value of its assets
which made them impair goodwill.

Goodwill tested for impairment annually.

Significant property and equipment assets. This increased with the acquisition of
Hollywood.

Liabilities
Expect to incur significant interest liability due to the funds borrowed for Hollywood
acquisition. No debt outstanding prior to this.

Significant long term debt liability on Senior Credit.

Revenue
After Hollywood acquisition, revenue has shifted more towards product sales than rental
revenue. This was caused mainly by the gaming sector

Predicting increased revenues in the game segment. Closure of stores results in increased
write-off resulting in increased operating expense and reducing net income. Hollywood
acquisition resulted in lower G&A expense because expense to revenue percentage was
lower for Hollywood.

Impairment losses recorded for impairment of goodwill and intangible assets made the
management revise the estimates for 2006 because earnings were weaker than
expectation.

Changing the way stock compensation is recorded. Will no longer be allowed to use the
intrinsic value arrproach. As a result, the amount of compensation expense will not be
affected by the changes in the trading value of common stock.

Hollywood and Game Crazy have always operated on very low margins.
Income:
Change in estimating residual value of VHS movies resulted in higher cost of sales and
hence lower net income.

Due to their acquisition of Hollywood Video, they registered substantial goodwill during
2005 which made them record a loss of $476 million for 2005.

Hollywood’s extending viewing fees reduced operating income resulting in the revenues
being lower than the actual cash collected from customers.

Expect future tax liabilities to be lower due to the significant goodwill impairment
charges recorded.

Material Weaknesses
Jan 2006, SEC identified 4 material weaknesses in their internal controls which included
ineffective management review and ineffective communication of accounting policies.

Sep 2005, the dividend scheme was paused and then deferred indefinitely. Revenues saw
a significant jump after acquisition of Hollywood.

Lot of pending lawsuits against Hollywood and Movie Gallery which might impact their
net income, based on the ruling in these lawsuits.

Plan to implement internal control changes in 2006, to address these weaknesses.

Reclassification – Purchases
All purchases of rental inventory has been reflected as operating cash flow. These were
reflected as investing activities. This reclass had no effect on net income. It affected cash
flow statements.

BLOCKBUSTER

Seeing the need for consolidation in the video rental market.