Netflix, Inc. is an American streaming service that lets subscribers watch television shows and movies.
The original Complaint alleges that Netflix and certain of its officers failed to disclose the number of subscriber cancellations being suffered by the Company, even as they repeatedly touted the large number of new subscribers being added to the Company's subscriber base. The Complaint further alleges that they also consistently understated the Company's churn rate (the percentage of its subscribers that canceled per month). They achieved this by using an improper calculation of the rate that produced an artificially low churn rate in quarters in which the Company was adding substantial numbers of new subscribers.
The standard definition of churn rate (and the definition used by other publicly traded companies that report churn rate such as Sprint and Nextel Partners) is "the percentage of participants who discontinue their use of a service divided by the average number of total participants during a given period of time." Netflix instead divided canceling subscribers by subscribers at the beginning of the period plus subscriber additions.
Because beginning subscribers plus new subscribers were consistently a larger number than average subscribers throughout the Class Period, the Company reported an artificially low churn rate throughout the Class Period by erasing the effect that canceling subscribers had on average subscribers during each period.
Moreover, it is alleged that the Company repeatedly made statements throughout the Class Period that its churn rate was declining to "record lows," when in fact in some of these quarters its churn rate was markedly rising. For example, in the third quarter of 2003, Netflix claimed that its churn rate had reached a new record low of 5.2% when in fact its churn rate had risen from 7% to 7.7% during the quarter.
Disclosure of actual subscriber cancellations and the actual churn rate was critically important for investors analyzing the Company's prospects and the potential of its business model. The Company spends approximately $35 in marketing expense to acquire each new subscriber. Had investors known that the Company was being forced continuously to replenish its subscriber base through additional marketing expenditures; it would have called into question the potential long-term profitability of the Company and the viability of its business model. In other words, the Company's artificially low claimed churn rate obscured the fact that it was not retaining many subscribers long enough to break even on them.
The truth came to light when, after the market closed on July 15, 2004, the Company issued an earnings release which, for the first time, disclosed the number of subscriber cancellations during previous quarters. Specifically, the press release stated that, while the Company had added 537,000 new subscribers during the second quarter, it had suffered 422,000 subscriber cancellation, meaning 72% of the Company's 583,000 new subscribers in the second quarter of 2004 had merely replaced subscribers who had canceled. The release also showed that 41% of the Company's 760,000 new subscribers in the second quarter had merely replaced subscribers who had canceled, and 71% of the Company's 327,000 new subscribers in the second quarter of 2003 had merely replaced subscribers who had canceled.
In response, Netflix shares declined from $32 per share to $20 per share over the next two days, a decline of 38%. During the Class Period, the shares had traded as high as $39.77 per share, during which period Hastings, McCarthy and Kilgore sold approximately $13 million in Netflix shares.
As summarized by the Company’s FORM 10-Q for the quarterly period ended September 30, 2005, 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. These class action suits were consolidated in January 2005, and a consolidated Complaint was filed on February 24, 2005. The Complaint alleges violations of certain federal securities laws, seeking unspecified damages on behalf of a class of purchasers of our common stock between October 1, 2003 and October 14, 2004. The Plaintiffs allege that the Company made false and misleading statements and omissions of material facts based on its disclosure regarding 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 its officers of Section 20A of Securities Exchange Act of 1934. On June 28, 2005, the Court dismissed the action with leave to amend. Plaintiffs did so amend, and the Company filed a motion to dismiss the amended Complaint. A hearing on the motion to dismiss was scheduled for November 17, 2005.
According to the Dismissal Order, signed by U.S. District Judge William Alsup on November 18, 2005, because no Defendant made a false statement actionable under federal securities law, Plaintiffs have failed to state a valid claim and there is no need to consider other elements of a valid 10(b) claim, such as scienter. The Complaint is dismissed without leave to amend for the reasons stated above. The Clerk is directed to close the case. That same day, the Court entered the Final Judgment in favor of the Defendants.
