Intangible Assets

Intangible assets and accumulated amortization consisted of the following:

Studio Intangible Assets:

During 2000, in connection with revenue sharing agreements with three studios, the Company agreed to issue each studio an equity interest equal to 1.204 percent of the Company’s fully diluted equity securities outstanding in the form of Series F Non-Voting Convertible Preferred Stock (“Series F Preferred Stock”). In 2001, in connection with revenue sharing agreements with two additional studios, the Company agreed to issue each studio an equity interest equal to 1.204 percent of the Company’s fully diluted equity securities outstanding in the form of Series F Preferred Stock.

The Company’s obligation to maintain the studios’ equity interests at an aggregate of 6.02 percent of the Company’s fully diluted equity securities outstanding terminated immediately prior to its initial public offering in May 2002. The studios’ Series F Preferred Stock automatically converted into an aggregate of 3,192,830 shares of common stock upon the closing of the Company’s initial public offering.

The Company measured the original issuances and any subsequent adjustments using the fair value of the securities at the issuance and any subsequent adjustment dates. The fair value was recorded as intangible assets with a corresponding credit to additional paid-in capital. The intangible assets are being amortized to cost of subscription revenues ratably over the remaining terms of the agreements which initial terms were three to five years.

Strategic Marketing Alliance Intangible Assets:

During 2001, in connection with a strategic marketing alliance agreement, the Company issued 416,440 shares of Series F Preferred Stock. These shares automatically converted into 277,626 shares of common stock upon the closing of the Company’s initial public offering. Under the agreement, the strategic partner committed to provide, on a best-efforts basis, a stipulated number of

Netflix, Inc.

Notes to Consolidated Financial Statements - Continued

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

impressions to a co-branded Web site and the Company’s Web site over a period of 24 months. In addition, the Company was allowed to use the partner’s trademark and logo in marketing the Company’s subscription services. The Company recognized the fair value of these instruments as intangible assets with a corresponding credit to additional paid-in capital. The intangible assets have been fully amortized on a straight-line basis to marketing expense over the two-year term of the agreement.

Property and Equipment

Property and equipment are carried at cost less accumulated depreciation. Depreciation is calculated using the straight-line method over the shorter of the estimated useful lives of the respective assets, generally up to three years, or the lease term, if applicable.

Revenue Recognition

Subscription revenues are recognized ratably during each subscriber’s monthly subscription period. Refunds to customerssubscribers are recorded as a reduction of revenues. Revenues from sales of used DVDs are recorded upon shipment.

Cost of Revenues

Cost of subscription revenues consists of revenue sharing expenses, amortization of the DVD library, amortization of intangible assets related to equity instruments issued to studios, and postage and packaging expenses related to DVDs shippedprovided to paying subscribers. Cost of DVD sales includes the salvage value of used DVDs that have been sold. Revenue sharing expenses are recorded as DVDs subject to revenue sharing agreements are shipped to subscribers. Cost of DVD sales include the net book value of the DVDs sold and, where applicable, a contractually specified percentage of the sales value for the DVDs that are subject to revenue share agreements.

Netflix, Inc.

Notes to Condensed Consolidated Financial Statements (continued)

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

Fulfillment

Fulfillment expenses represent those costs incurred in operating and staffing the Company’s fulfillment and customer service centers, including costs attributable to receiving, inspecting and warehousing the Company’s DVD library. Fulfillment expenses also include credit card fees.

Technology and Development

Technology and development expenses consist of payroll and related costs incurred in developing, testing, maintaining and modifying the Company’s Web site,Site, its recommendation service, developing solutions for downloading solutions,movies to subscribers, telecommunications systems and infrastructure and other internal-use software systems. Technology and development expenses also include depreciation on the computer hardware and capitalized software.

Marketing

Marketing expenses consist of payroll and related costs,expenses and advertising public relations, payments toexpenses. Advertising expenses include marketing affiliates who drive subscriber traffic to the Company’s Web siteprogram expenditures and other costs related to promotional activities, including revenue sharing expenses, postage and packaging expenses and DVD library amortization related to free-trialfree trial periods. Advertising costs are expensed as incurred except for advertising production costs, which are expensed the first time the advertising is run.

In November of 2002, the Emerging Issues Task Force (“ EITF”) reached a consensus on Issue No. 02-16,Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor, which addresses the accounting for cash consideration given to a reseller of a vendor’s products from the vendor. The Company and its vendors participate in a variety of cooperative advertising programs and other promotional programs in which the vendors provide the Company with cash consideration in exchange for marketing and advertising of the vendor’s products. If the consideration received represents reimbursement of specific incremental and identifiable costs incurred to promote the vendor’s product, it is recorded as an offset to the associated marketing expense incurred. Any reimbursement greater than the costs incurred is recognized as a reduction of cost of revenues when recognized in the Company’s statement of operations.

Revenue sharing expenses

The Company acquires DVDs from studios and distributors through either direct purchases or revenue sharing agreements. The revenue sharing agreements enable the Company to obtain DVDs at a lower upfront cost than under traditional direct purchase arrangements. Under the revenue sharing agreements, the Company shares 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, the Company generally has the option of returning the DVD title to the studio, destroying the title or purchasing the title. The revenue sharing expenses are expensed to ‘Cost of Subscription Revenues’ as DVDs subject to revenue sharing agreements are shipped to subscribers.

The terms of some revenue sharing agreements with studios obligate the Company to make minimum revenue sharing payments for certain titles. The Company amortizes minimum revenue sharing prepayments (or accretes 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.

Amortization of DVD library

The Company remits an upfront payment to acquire titles from the studios and distributors. This payment includes a contractually specified initial fixed license fee that is capitalized and amortized in accordance with the Company’s DVD library amortization policy. The Company amortizes its DVD library, less estimated salvage value, on a “sum-of-the-months” accelerated basis over its estimated useful life. The useful life of the new-release DVDs and back-catalogue DVDs is estimated to be 1 year and 3 years, respectively. In estimating the useful life of its DVD library, the Company takes into account library utilization as well as an estimate for lost or damaged DVDs.

Prior to July 1, 2004, the Company amortized the cost of its 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 a periodic evaluation of both new release and back-catalogue utilization for amortization purposes, the Company determined that back-catalogue titles have a significantly longer life than previously estimated. As a result, the Company revised the 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 was to more accurately reflect the productive life of these costsassets. In accordance with Accounting Principles Board Opinion No. 20,Accounting Changes (“APB 20”), the change in life has been accounted for as incurred.a

Netflix, Inc.

Notes to Condensed Consolidated Financial Statements (continued)

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

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 $4.4 million lower, net income was $4.4 million higher and net income per share was $0.08 higher for the three months ended March 31, 2005.

In addition, the Company also determined that it is selling fewer previously rented DVDs than estimated but at an average selling price higher than historically estimated. The Company therefore revised its estimate of salvage values, on direct purchase DVDs in the third quarter of 2004. For those direct purchase DVDs that the Company estimates it will sell at the end of their useful lives, a salvage value of $3.00 per DVD has been provided effective July 1, 2004. For those DVDs that the Company does not expect to sell, no salvage value is provided. Simultaneously with the change in accounting estimate of expected salvage values the Company recorded a write-off of approximately $1.9 million related to non-recoverable salvage value in the third quarter of 2004.

DVD library and accumulated amortization are as follows:

Intangible Assets

Intangible assets and accumulated amortization consisted of the following:

The unamortized balance of the studio intangible asset will be fully amortized in 2005.

Stock-Based Compensation

Prior to the second quarter of 2003, the Company accounted for its stock-based employee compensation plans using the intrinsic-value method of accounting. During the second quarter ofIn 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation,as amended by SFAS No. 148,Accounting for Stock-Based Compensation – Transition and Disclosure, an Amendment of FASB Statement No. 123,for stock-based employee compensation. The Company elected to apply the retroactive restatement method under SFAS No. 148 and all prior periods presented have been restated to reflect the compensation costs that would have been recognized had the fair value recognition provisions of SFAS No. 123 been applied to all awards granted to employees.

During the third quarter of 2003, the Company began granting stock options to its employees on a monthly basis. Such stock options are designated as non-qualified stock options and vest immediately, in comparison with the three to four-year vesting periods for stock options granted prior to the third quarter of 2003. As a result of immediate vesting, stock-based compensation expense determined under SFAS No. 123 is fully recognized upon the stock option grants. For those stock options granted prior to the third quarter of 2003 with three to four-year vesting periods, the Company continues to amortize the deferred compensation associated with the stock options over their remaining vesting periods.

Netflix, Inc.

Notes to Consolidated Financial Statements - Continued

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

Fair value was estimated at the date of grant using the Black-Scholes pricing model with the following assumptions:

Netflix, Inc.

Notes to Condensed Consolidated Financial Statements (continued)

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

In estimating expected volatility, the Company considered historical volatility, volatility in market-traded options on its common stock and other relevant factors in accordance with SFAS No. 123. The Company will continue to monitor these and other relevant factors used to estimate expected volatility for future option grants. The Company bases its expected life assumption on historical experience as well as the terms and vesting periods of the options granted. Beginning with the second quarter of 2004, the Company bifurcated its option grants into two employee groupings who have exhibited different exercise behavior and changed the estimate of the expected life from 1.5 years for all option grants in the first quarter of 2004 to 1 year for one group and 2.5 years for the other group in the second quarter of 2004. Had the Company continued to use the expected life of 1.5 years for all option grants in the second quarter of 2004, stock-based compensation expense would have decreased by approximately $234, basic net income per share would have remained unchanged, and diluted net income per share would have increased by $0.01 per share.

Income Taxes

The Company accounts for income taxes using the asset and liability method. Deferred income taxes are recognized by applying enacted statutory 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.

Net IncomeIncome(Loss) Per Share

Basic net income (loss) per share is computed using the weighted-average number of outstanding shares of common stock during the period. Diluted net income per share is computed using the weighted-average number of outstanding shares of common stock and, when dilutive, potential common shares outstanding during the period. Potential common shares consist primarily of incremental shares issuable upon the assumed exercise of stock options and warrants to purchase common stock using the treasury stock method.

The shares used in the computation of net income per share are as follows (rounded to the nearest thousand):

For the three months ended September 30, 2003 andMarch 31, 2004 and for2005, potential common shares from the nine months ended September 30, 2003 and 2004,assumed exercise of warrants and employee stock options with exercise prices greater than the average market price of the common stock were excluded from the diluted calculation as their inclusion would have been anti-dilutive.anti-dilutive as the Company was in a net loss position. The following table summarizes the outstanding potential common shares excluded from the diluted calculation (rounded to the nearest thousand):

Netflix, Inc.

Notes to Consolidated Financial Statements - Continued

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

Comprehensive IncomeLoss

The Company’s comprehensive incomeloss consists of net income,loss and net unrealized gains (losses) on available-for-sale investments and foreign currency translation adjustments. During the second quarter of 2004, the Company liquidated all of its available-for-sale investments.

The components of comprehensive incomeloss are as follows:

Segment Information

The Company is an online movie rental subscription service and substantially all revenues are derived from monthly subscription fees. The Company is organized into two geographical segments: United States and International. We present our segment information along the same lines that our chief operating decision maker uses to review our operating results in assessing performance and allocating resources. We measure operating results of our segments using an internal performance measure of direct segment operating expenses that excludes stock-based compensation which is not allocated to segment results. All other centrally-incurred operating costs are fully allocated to segment results. There are no internal revenue transactions between our reporting segments.

Summarized information by segment is as follows (in thousands):

Netflix, Inc.

Notes to Consolidated Financial Statements - Continued

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

Legal Proceedings

The Company is a partyFrom time to lawsuitstime, in the normal course of its business.operations, the Company is a party to litigation matters and claims, including claims relating to employee relations and business practices. Litigation can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. Listed below are material legal proceedings to which the Company is a party. 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.

Netflix, Inc.

Notes to Condensed Consolidated Financial Statements (continued)

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

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, theThese class action suits were consolidated in January 2005, and a consolidated complaint was filed byon February 24, 2005, and the following named plaintiffs, in each case individually and on behalf of others similarly situated, on the following dates:lead plaintiff is 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.Noel. The complaints allegecomplaint alleges violations of certain federal securities laws, and seekseeking unspecified damages on behalf of a class of purchasers of the Company’s common stock between October 1, 2003 and July 15,October 14, 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 and delivery speed, 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’sits 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 makesasserts claims of, among other things, false advertising, unfair and deceptive trade practices, breach of contract and otheras well as 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,Company’s behalf, 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,Company’s behalf, 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 December 2004, the Court stayed this proceeding pending resolution of a similar action brought by Miles L. Mitzner, in thousands, except shares, per share data and percentages)the United States District Court for the Northern District of California. Although the action brought by Mr. Mitzner was dismissed in February 2005, as of the date of the filing of this report the stay in the Staehr action had not been lifted by the Superior Court.

Recent Accounting Pronouncements

In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 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 03-1 developed a basic three-step model to evaluate whether an impairment is other-than-temporary. In September 2004, the Financial Accounting Standards Board (“FASB”) approved issuing a Staff Position to delay the requirement to record impairment losses under EITF 03-01, but broadened the delay’s scope to include additional types of securities. As proposed, the delay would have applied only to those debt securities described in paragraph 16 of EITF 03-01, the Consensus that provides guidance for determining whether an investment’s impairment is other-than-temporary and should be recognized in income. The approved delay will apply to all securities within the scope of EITF 03-01 and is expected to end when new guidance is issued and comes into effect. When effective, the application of EITF 03-1 is not expected to have an impact on the Company’s financial statements.

Subsequent EventsIntellectual Property Indemnification Obligations

In October 2004,the ordinary course of business, the Company announced that, effective November 1, 2004,has entered into contractual arrangements under which it has agreed to provide indemnification of varying scope and terms to business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of the Company’s breach of such agreements and out of intellectual property infringement claims made by third parties. In these circumstances, payment by the Company would reduceis conditional on the subscription priceother party making a claim pursuant to the procedures specified in the particular contract, which procedures typically allow the Company to challenge the claims. Further, the Company’s obligations under these agreements may be limited in terms of time and/or amount, and in some instances, the Company may have recourse against third parties for certain payments made by it under these agreements. In addition, the Company has entered into indemnification agreements with its directors and certain of its standardofficers that will require it, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service from $21.99as directors or officers. The terms of such obligations vary.

It is not possible to $17.99. At that time,make a reasonable estimate of the Company also postponed, for at least one-year,maximum potential amount of future payments under these or similar agreements due to the launchconditional nature of its servicethe Company’s obligations and the unique facts and circumstances involved in each particular agreement. No amount has been accrued 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, in anticipation of increased competition from new market entrants.accompanying financial statements with respect to these indemnification obligations.

Item 2. 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, includinglaws. These forward-looking statements regarding international expansion,include, but are not limited to, statements regarding: operating expenses; gross margin; liquidity; subscriber acquisition and retention; churn; developments in downloading,downloading; revenue per subscriber,average paying subscriber; and impacts arising from our price change, subscriber churn, movie rentals,DVD library investments, marketing expenses, and subscriber acquisition cost and liquidity.cost. These forward-looking statements are subject to risks and uncertainties that could cause actual results and events to differ, including: our ability to effectively execute expansion of our business into 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.differ. 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 20032004 annual report on Form 10-K filed with the Securities and Exchange Commission on February 27, 2004.March 15, 2005.

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 Businesscritical accounting policies have not changed from our year ended December 31, 2004. For a complete discussion of our critical accounting policies, please refer to our 2004 annual report on Form 10-K.

Overview

Our Business

We are the largest online movie rental subscription service in the United States, providing approximately 2,229,000more than 3,000,000 subscribers access to a comprehensive library of more than 25,00040,000 movie, television and other filmed entertainment titles. For a monthly subscription fee, our standardOur most popular subscription plan allows subscribers to have up to 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 acharges for $17.99 per month. In addition to this plan, we offer other subscription plans with different price points and varying service levels. Subscribers select titles at our Web site (www.netflix.com) aided by our proprietary recommendation service, receive them on DVD by first-classU.S. mail and return them to us at their convenience using our prepaid mailers. OnceAfter a title has been returned, we mail the next available title in a subscriber’s queue. ForThe terms and conditions by which subscribers utilize our service and a more detailed discussiondescription of how 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 Metricsservice works can be found atwww.netflix.com/TermsOfUse.

Management periodically reviews certain keyOur business metricshas grown rapidly since inception, resulting in ordersubstantially increased revenues. Our growth has been fueled by the rapid adoption of DVDs as a medium for home entertainment as well as increased awareness of online DVD rentals. We expect that our business will continue to evaluategrow as the effectivenessmarket for online DVD rentals continues to grow, a reflection of our operational strategies, allocate resourcesboth the convenience and maximizevalue of the financial performance of our business. These key business metrics include the following:

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 Initiativessubscription rental model.

We have seen increased direct competitionderive substantially all of our revenues from Blockbuster, which launched its online servicemonthly subscription fees. In the first quarter of 2005, we continued to show strong growth in August 2004,our subscription base and subscription revenues. However, despite our overall revenue growth, net loss was higher in the current quarter as compared to the same period a year ago as we have recently learned that Amazon is likely to offer soon a service that directly competes with us. Givenlowered the changing competitive landscape, we announced in October 2004, that we would, effective November 1, 2004, reduce themonthly subscription price of our standardmost popular service from $21.99 to $17.99. We also postponed, for at least one-year, the launch of our serviceplan in the United Kingdom so that we could focus on defending our market leadership position in the United States. In 2005, we intend to grow our 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 unable to successfully or profitably compete with current and new competitors, our business will be adversely affected and we may not be able to increase or maintain market share, revenues or profitability.

Barry McCarthy, who had announced plans to leave his position as Chief Financial Officer at the endfourth quarter of 2004 as previously disclosed, has announced that he would continue as the Chief Financial Officer for at least two additional years.while increasing our marketing spending in a highly competitive environment.

We continue to experience aggressive direct competition from Blockbuster. In particular, Blockbuster cut its standard subscription price twice during the last quarter of 2004 and currently has a price $3 below our most popular service price. In addition, Blockbuster has continued television advertising of its online offering. We also anticipate that other potential entrants, such as Amazon.com, will offer competing services, either directly or in conjunction with others. Our focus in 2005 will be to retain our leadership position despite the dynamic competitive landscape.

Additionally, we continue to invest resources to develop solutions for downloading movies to consumers. Our core strategy has been and remains to grow a large DVD subscription business; however, as technology and infrastructure develop to allow effective and convenient delivery of movies over the Internet, we intend to offer our subscribers the choice under one subscription of receiving their movies on DVD or by downloading, whichever they prefer. Although our solutions may be well in advance of meaningful demand for downloading services and we expect only modest consumer interest for the near term, we believe the demand for this technology will grow steadily over the next ten years.

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 CostsKey Business Metrics

We acquire DVDs from studiosManagement periodically reviews certain key business metrics in order to evaluate the effectiveness of our operational strategies, allocate resources and distributors through either direct purchases or revenue sharing agreements.maximize the financial performance of our business. The revenue sharing agreements enable us to obtain DVDs at a lower upfront cost than under traditional direct purchase arrangements. Underkey business metrics include 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.following:

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.

•

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.

PriorManagement believes it is useful to July 1, 2004, we amortized the costmonitor these metrics together and not individually as it does not make business decisions based upon any single metric. Please see “Results of our entire DVD library, including the capitalized portion of the initial fixed license fee,Operations” below for further discussion on a “sum-of-the-months” accelerated basis over one year. However, based on our periodic evaluation of both new releasethese key business metrics.

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 have 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 salvage value of $3.00 per DVD has been 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.

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 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.

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.

Three and Nine Months Ended September 30, 2003March 31, 2004 Compared to Three and Nine Months Ended September 30, 2004March 31, 2005

Revenues

We currently generate all of our revenues in the United States. We derive substantially all of our revenues from monthly subscription fees and recognize subscription revenues ratably during each subscriber’s monthly subscription period. In addition, we generate a small portion of our revenues from the sale of used DVDs and recognize such revenues when the DVDs are shipped.

The increase in our subscription revenues for the three and nine months ended September 30, 2004March 31, 2005 in comparison with the same prior-year periodsperiod was primarily attributable to an increasesubstantial growth in the average number of paying subscribers as summarized in the table above.above, offset in part by a decline in average monthly subscription revenue per paying subscriber. We believe the increase in the number of paying subscribers was driven primarily by the continuing consumer adoption of DVD players, increased consumer awareness of our servicethe benefits of online DVD rentals and continuing improvements in our service. In addition, the increase in our subscription revenues was partially attributable to an increaseThe decline in the average monthly subscription revenue per paying subscriber aswas a result of the price increase implemented in June 2004. As a resultdecrease of our announced price decreasemost popular service plan from $19.95 in the first quarter of 2004 to be implemented$17.99 in November 2004, wethe first quarter of 2005. We expect the average monthly subscription revenue per paying subscriber to decrease in the fourth quarter of 2004.