Netflix, Inc.

Notes to Consolidated Financial Statements - Continued

(in SFAS No. 131, evaluates performance, makes operating decisionsthousands, except shares, per share data and allocates resources based on financial data consistent with the presentation in the accompanying financial statements.percentages)

Legal Proceedings

The Company is a party to lawsuits in the normal course of its business. Litigation can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. The Company believes that it has defenses to the cases set forth below and is vigorously contesting these matters. An unfavorable outcome of any of these matters could have a material adverse effect on the Company’s financial position, liquidity or results of operations.

Between July 22 and September 9, 2004, seven purported securities class action suits were filed in the United States District Court for the Northern District of California against the Company and, in the aggregate, Reed Hastings, W. Barry McCarthy, Jr., and Leslie J. Kilgore. Specifically, the suits were filed by the following named plaintiffs, in each case individually and on behalf of others similarly situated, on the following dates: Todd Noel, July 22, 2004; Eugene Rausch, July 26, 2004; Zoe Myerson, August 6, 2004; Shay Crawford, August 9, 2004; Jan. B. Martin, August 16, 2004; Charles K. Lee, September 8, 2004; and Crayton D. Leavitt, September 9, 2004. The complaints allege violations of certain federal securities laws and seek unspecified damages on behalf of a class of purchasers of the Company’s common stock between October 1, 2003 and July 15, 2004. The plaintiffs allege that the Company made false and misleading statements and omissions of material facts based on the Company’s disclosure regarding subscriber churn, claiming alleged violations by each named defendant of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder and alleged violations by certain of the Company’s officers of Section 20A of Securities Exchange Act of 1934. On October 15, 2004, the plaintiff in one of the actions amended his complaint to extend the class period to October 14, 2004. The Company anticipates that all of the pending class actions will be consolidated and that an amended consolidated complaint will be filed.

On August 13, 2004, Miles L. Mitzner, a shareholder claiming to be acting on the Company’s behalf, filed a shareholder derivative suit in the United States District Court for the Northern District of California against certain officers and certain current and former members of the board of directors, specifically Reed Hastings, W. Barry McCarthy, Jr., Jay C. Hoag, A. Robert Pisano, Michael Ramsay and Timothy M. Haley. Mr. Mitzner claims that the named defendants breached their fiduciary duties by allowing allegedly false and misleading statements to be made regarding, among other things, subscriber churn. Mr. Mitzner also claims that the named defendants illegally traded the Company’s stock while in possession of material nonpublic information. The lawsuit seeks, on behalf of the Company, unspecified compensatory and enhanced damages, disgorgement of profits earned through alleged insider trading, recovery of attorneys’ fees and costs, and other relief.

On September 14, 2004, BTG International Inc. filed suit against the Company and other, unaffiliated companies in the United States District Court for the District of Delaware. The complaint alleges that the Company infringed U.S. Patent No. 5,717,860 entitled “Method and Apparatus for Tracking the Navigation Path of a User on the World Wide Web.” The complaint also alleges infringement of another patent by certain of the other named defendants, not including the Company. The complaint seeks unspecified compensatory and enhanced damages, interest and fees, and to permanently enjoin the defendants from infringing the patents in the future.

On September 23, 2004, Frank Chavez, individually and on behalf of others similarly situated, filed a class action lawsuit against the Company in California Superior Court, City and County of San Francisco. The complaint makes false advertising, unfair and deceptive trade practices, breach of contract and other claims relating to the Company’s statements regarding DVD delivery times. The complaint seeks restitution, disgorgement, damages, and injunction and specific performance and other relief.

On October 19, 2004, Doris Staehr and Steve Staehr, shareholders claiming to be acting on behalf of the Company, filed a shareholder derivative suit in the Superior Court of the State of California for the County of Santa Clara against certain officers and certain current and former members of the board of directors, specifically Reed Hastings, Barry McCarthy, Thomas R. Dillon, Leslie J. Kilgore, Richard Barton, Timothy Haley, Jay Hoag, A. Robert Pisano, Michael Schuh and Michael Ramsay. The plaintiffs claim that the named defendants breached their fiduciary duties by allowing allegedly false and misleading statements to be made regarding, among other things, subscriber churn. They also claim that the named defendants illegally traded the Company’s stock while in possession of material nonpublic information. In addition, the plaintiffs assert claims for abuse of control, gross mismanagement, waste and unjust enrichment. The lawsuit seeks, on behalf of the Company, unspecified compensatory and enhanced damages, disgorgement of profits earned through alleged insider trading, recovery of attorneys’ fees and costs, and other relief.

Netflix, Inc.

Notes to Consolidated Financial Statements - Continued

(in thousands, except shares, per share data and percentages)

Recent Accounting Pronouncements

In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-1,The “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.Investments” (“EITF Issue No.03-1”). EITF 03-1 provides guidance on other-than-temporary impairment models for marketable debt and equity securities accounted for under SFAS No. 115,Accounting for Certain Investments in Debt and Equity Securities, and SFAS No. 124,Accounting for Certain Investments Held by Not-for-Profit Organizations, and non-marketable equity securities accounted for under the cost method. EITF Issue No. 03-1 developed a basic three-step model to evaluate whether an impairment is other-than-temporary. The provisions are effective for reporting periods beginning after June 15,In September 2004, and the disclosure requirements are effective for annual reporting periods ending after June 15, 2004. The Company liquidated all of its short-term investments in the second quarter of 2004 and, therefore, does not expect the adoption of EITF Issue No. 03-1 to have a material effect on its results of operations and financial condition.

Netflix, Inc.

Notes to Financial Statements - Continued

(in thousands, except shares, per share data and percentages)

In December 2003, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 104,Revenue Recognition, which supersedes SAB No. 101,Revenue Recognition in Financial Statements. The primary purpose of SAB No. 104 is to rescind accounting guidance contained in SAB No. 101 related to multiple element revenue arrangements, superseded as a result of the issuance of EITF Issue No. 00-21,Revenue Arrangements with Multiple Deliverables. Additionally, SAB No. 104 rescinds the SEC’s “Revenue Recognition in Financial Statements Frequently Asked Questions and Answers” (“the FAQ”) issued with SAB No. 101 that had been codified in SEC Topic 13,Revenue Recognition. Selected portions of the FAQ have been incorporated into SAB No. 104. While the wording of SAB No. 104 has changed to reflect the issuance of EITF Issue No. 00-21, the revenue recognition principles of SAB No. 101 remain largely unchanged by the issuance of SAB No. 104. The adoption of SAB No. 104 did not have a material impact on the Company’s financial position, results of operations or cash flows.

In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51, which addressesapproved issuing a Staff Position to delay the requirement forto record impairment losses under EITF 03-01, but broadened the consolidation by business enterprisesdelay’s scope to include additional types of variable interest entities as definedsecurities. As proposed, the delay would have applied only to those debt securities described in paragraph 16 of EITF 03-01, the Interpretation. In December 2003, the FASB issued a revised Interpretation No. 46 (“FIN 46R”), which expands the criteriaConsensus that provides guidance for consideration in determining whether a variable interest entityan investment’s impairment is other-than-temporary and should be consolidated. Public companies mustrecognized in income. The approved delay will apply FIN 46R to variable interest entities consideredall securities within the scope of EITF 03-01 and is expected to be special purpose entities no later thanend when new guidance is issued and comes into effect. When effective, the end of the first reporting period that ended after December 15, 2003, and no later than the first reporting period that ended after March 15, 2004 for all other entities. The application of FIN 46R didEITF 03-1 is not expected to have an impact on the Company’s financial statements, as the Company does not engage in transactions with any variable interest entities.statements.

Subsequent EventEvents

In JulyOctober 2004, purported securities class actions were filedthe Company announced that, effective November 1, 2004, the Company would reduce the subscription price of its standard service from $21.99 to $17.99. At that time, the Company also postponed, for at least one-year, the launch of its service in the United Kingdom so that the Company could focus on defending its market leadership position in the online movie rental subscription business in the United States, District Court for the Northern Districtin anticipation of California against the Company and several of its officers. The complaints allege violations of the federal securities laws and seek unspecified damages on behalf of a class of purchasers of the Company’s common stock between October 1, 2003 and July 15, 2004. The Company has not been served with the complaints but intends to vigorously defend against such suits. An unfavorable outcome of this litigation could have a material adverse effect on the Company’s financial position, liquidity or results of operations.increased competition from new market entrants.

Item 22.. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

This quarterly report on Form 10-Q contains certain forward-looking statements within the meaning of the federal securities laws, including statements regarding international expansion, developments in downloading, revenue per subscriber, impacts arising from our price change, subscriber churn, movie rentals, subscriber acquisition cost and liquidity. These statements are subject to risks and uncertainties that could cause actual results and events to differ, including: our ability to effectively execute effectively expansion of our business into international markets and downloading; managerial, operational, administrative and financial resource constraints; legal costs associated with defending litigation matters; competition; our ability to manage our growth, in particular managing our subscriber acquisition cost as well as the mix content delivered to our subscribers; our ability to attract new subscribers and retain existing subscribers; consumer spending on DVD players, DVDs and related products; and widespread consumer adoption of different modes of viewing in-home filmed entertainment. A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included as part of our 2003 annual report on Form 10-K filed with the Securities and Exchange Commission on February 27, 2004.

We undertake no obligation to revise or publicly release the results of any revision to any forward-looking statements contained in this quarterly report on Form 10-Q, or to explain why actual results differ.

Our Business

We are the largest online movie rental subscription service in the United States, providing more than 2,093,000approximately 2,229,000 subscribers access to a comprehensive library of more than 25,000 movie, television and other filmed entertainment titles. For a monthly subscription fee, our standard subscription plan allows subscribers to have three titles out at the same time with no due dates, late fees or shipping charges. Subscribers can view as many titles as they want in a month. Subscribers select titles at our Web site (www.netflix.com) aided by our proprietary recommendation service, receive them on DVD by first-class mail and return them to us at their convenience using our prepaid mailers. Once a title has been returned, we mail the next available title in a subscriber’s queue. For a more detailed discussion of our business and the risks and uncertainties associated with our business, please refer to our 2003 annual report on Form 10-K filed with the Securities and Exchange Commission on February 27, 2004.

On January 16, 2004, our Board of Directors approved a two-for-one stock split in the form of a stock dividend on all outstanding shares of our common stock. As a result of the stock split, our stockholders received one additional share for each share of common stock held on the record date of February 2, 2004. The additional shares of common stock were distributed on February 11, 2004.

Key Business Metrics

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

satisfaction, which reduces subscriber churn and increases word-of-mouth advertising about our service. As a result, marketing expense may fall as a percentage of revenues and operating margins rise, offsetting the impact of a reduction in gross margin. We can also make trade-offs between our DVD library investments which have an inverse relationship with subscriber churn and subscriber acquisition cost. For example, an increase in our DVD library investments may improve customer satisfaction and lower subscriber churn, and hence increase the number of new subscribers acquired via word-of-mouth. This in turn may allow us to accelerate our subscriber growth for a given level of marketing spending.

Recent Developments and Initiatives in 2004

InWe have seen increased direct competition from Blockbuster, which launched its online service in August 2004, and we have recently learned that Amazon is likely to offer soon a service that directly competes with us. Given the current year,changing competitive landscape, we will continueannounced in October 2004, that we would, effective November 1, 2004, reduce the subscription price of our standard service from $21.99 to $17.99. We also postponed, for at least one-year, the launch of our service in the United Kingdom so that we could focus on defending our online DVD rental subscription servicemarket leadership position in the United States. In addition2005, we intend to grow our core focus,subscriber base as fast as possible while maintaining break-even on an annual basis. Under this strategy, we may incur losses during times of heavy subscriber growth but will endeavor to break-even on a GAAP basis for the full year. Although our strategy is aimed at maintaining domestic market leadership in the face of increasing competition, there can be no assurance that we will be able to compete effectively against existing competitors, such as Blockbuster, Wal-Mart and Hollywood Entertainment, or against potential new entrants into the online movie rental subscription business such as Amazon, at our new pricing levels or at even lower price points in the future. If we are planning on executing the following initiatives in 2004:

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures of contingent assets and liabilities in our financial statements and accompanying notes. The Securities and Exchange Commission 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. Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions.

Amortization of DVD Library and Upfront Costs

We acquire DVDs from studios and distributors through either direct purchases or revenue sharing agreements. The revenue sharing agreements enable us to obtain DVDs at a lower upfront cost than under traditional direct purchase arrangements. Under the revenue sharing agreements, we share a percentage of the actual net revenues generated by the use of each particular title with the studios over a fixed period of time, or the Title Term, which is typically twelve months for each DVD title. At the end of the Title Term, we have the option of either returning the DVD title to the studio or purchasing the title.

In addition, we remit an upfront payment to acquire titles from the studios and distributors under revenue sharing agreements. This payment includes a contractually specified initial fixed license fee that is capitalized and amortized in accordance with our DVD library amortization policy. In some cases, this payment also includes a contractually specified prepayment of future revenue sharing obligations that is classified as prepaid revenue sharing expense and is charged to expense as future revenue sharing obligations are incurred.

We amortizePrior to July 1, 2004, we amortized the cost of our entire DVD library, including the capitalized portion of the initial fixed license fee, on a “sum-of-the-months” accelerated basis over one year. However, based on our periodic evaluation of both new release

and back-catalogue utilization for amortization purposes, we determined that back-catalogue titles have a significantly longer life than previously estimated. As a result, we have revised our estimate of useful life for the back-catalogue DVD library from a “sum of the months” accelerated method using a one year life to the same accelerated method of amortization using a three-year life. The purpose of this change is to more accurately reflect the productive life of these assets. In accordance with APB 20, the change in life has been accounted for as a change in accounting estimate on a prospective basis from July 1, 2004. New releases will continue to be amortized over a one year period. As a result of the change in the estimated life of the back-catalogue library, total cost of revenues was $5.9 million lower, net income was $5.9 million higher and net income per diluted share was $0.09 higher for the three and nine months ended September 30, 2004.

We believe the use of the accelerated method is appropriate for the amortization of our DVD library and the initial fixed license fee because it approximates DVD utilization.

In addition, we normally experience heavy initial demand forhave also determined that we are selling fewer previously rented DVDs than estimated but at an average selling price higher than historically estimated. We have therefore revised our estimate of salvage values, on direct purchase DVDs. For those direct purchase DVDs that we estimate we will sell at the end of their useful lives, a title, which subsides gradually once the initial demandsalvage value of $3.00 per DVD has been satisfied. provided effective July 1, 2004. For those DVDs that we do not expect to sell, no salvage value is provided. As a result of this change in estimated salvage values, approximately $0.1 million lower salvage value was assigned to DVD purchases during the three and nine months ended September 30, 2004. Simultaneously with the adjustment to salvage value we recorded a write-off of approximately $1.9 million of non-recoverable salvage value. As a result of this write-off, total cost of revenues was $1.9 million higher, net income was $1.9 million lower and net income per diluted share was $0.03 lower for the three and nine months ended September 30, 2004, respectively.

We will continue to periodically evaluate the useful lives and salvage values of our DVD library for amortization purposes.

Stock-Based Compensation

We account for stock-based compensation expenses in accordance with the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123,Accounting for Stock-Based Compensation. The application of SFAS No. 123 requires significant judgment, including the determination of the expected life and volatility for stock options. To determine the expected life, we review the historical pattern of exercises of stock options as well as the terms and vesting periods of the options granted. In addition, our stock price has fluctuated significantly in recent periods, which affects our assumptions used in determining the volatility. We periodically review the assumptions used and changes in our assumptions could materially impact the amount of stock-based compensation expenses recorded in future periods.

Income Taxes

We record a tax provision, if any, for the anticipated tax consequences of our reported results of operations. In accordance with SFAS No. 109,Accounting for Income Taxes, the provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized.

No tax expense has yet been recorded because of our operating losses. Our deferred tax assets, primarily the tax benefits of these loss carryfowards,carryforwards, have been offset by a full valuation allowance because of our history of losses. If we subsequently determine that some or all deferred tax assets that were previously offset by a valuation allowance are realizable, the result would be a positive adjustment to earnings in the period such determination is made. We could have an income tax provision in future quarters if we become profitable for the current year and are subject to the corporate alternative minimum tax, or if we incur foreign taxes as a result of our international expansion.tax.

Results of Operations

The following table sets forth, for the periods presented, the line items in our 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, Notes to Financial Statements, and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this quarterly report on Form 10-Q.