3Q15: The Inevitable "Bump in the Road" Quarter

October 15, 2015 Netflix Inc 3Q15: The Inevitable "Bump in the Road" Quarter MORGAN STANLEY & CO. LLC Benjamin Swinburne, CFA Benjamin.Swinburne@morganstanley.com Thomas Yeh Thomas.Yeh@morganstanley.com +1 212 761-7527 +1 212 761-1740 Industry View Cautious Stock Rating Overweight Price Target $135.00 After three straight quarterly sub beats, we were due for an admittedly mixed quarter, with 3Q int'l ahead and domestic light. However, heading into the seasonally strong 4Q/1Q U.S. period and another batch of international launches, we would be buying any pullback and reiterate our OW. Positives from the results & outlook - int'l: The international results were supportive of the global growth bull case. Int'l sub growth in 3Q of 2.74mm exceeded the guidance of 2.4mm, likely led by a strong launch in Japan (explaining the stronger free subs and softer pay subs). The 4Q guidance of 3.5mm exceeded consensus of 3.17mm although a bit below our bullish 3.64mm expectation. We were also encouraged by lower international losses, both in 3Q results and 4Q guidance, suggesting the cost to launch new markets (Japan in 3Q and Southern Europe in 4Q) is perhaps lower than we expected and lower than major European market launches historically (on a per broadband household basis). Netflix Inc ( NFLX.O, NFLX US ) Media / United States of America Stock Rating Overweight Industry View Cautious Price target $135.00 Shr price, close (Oct 14, 2015) $110.23 Mkt cap, curr (mm) $48,299 52-Week Range $129.29-45.08 Fiscal Year Ending 12/14 12/15e 12/16e 12/17e ModelWare EPS ($) 4.32 0.20 0.29 1.27 Prior ModelWare EPS - 0.14 0.40 1.42 ($) EPS ($)** 4.32 0.26 0.29 1.27 Prior EPS ($)** - 0.19 0.40 1.42 Unless otherwise noted, all metrics are based on Morgan Stanley ModelWare framework ** = Based on consensus methodology e = Morgan Stanley Research estimates Positives from the results & outlook - U.S.: Domestic margin guidance for 4Q was also a positive, with margins expected to be up 600bp YoY in 4Q15 to 34% - ahead of the prior +200bp YoY guidance - and we continue to believe the company will likely exceed its 40% margin targets in the U.S. in 2020. Finally, while we continue to believe there will be a churn impact (voluntary churn) in 2016 from the step up in prices for previously grandfathered subscribers (many from $7.99 to $9.99), the company's expectations are that there will not be a large impact. Netflix's pricing power long-term is a key underpinning of our OW rating. Voluntary churn - customers that are cancelling the service - fell YoY in line with expectations. Where results or outlook fell short of expectations: Domestic net adds were ~270K below guidance, which in the context of a 40mm+ sub base is fairly immaterial, but nonetheless we believe both connects and churn were lower/higher respectively than expected. The 4Q domestic guide factors in continued elevated involuntary churn (customers that didn't or couldn't pay their credit card bills, or renewals that could not be processed), leading to a lower U.S. net adds outlook versus expectations. Putting the higher U.S. churn into context: Netflix does not report churn, but we believe that a fairly material % of its churn is involuntary given it uses credit card billing in the U.S. For cable operators, ~⅓ of churn is typically involuntary churn. If we exclude move churn (which is not a factor for Netflix), roughly ½ of churn is involuntary or non-pay churn. We would not be Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. 1

surprised if Netflix churn is roughly ½ involuntary as well. As a result, any issues in the U.S. impacting credit card processing (breaches, migration to chip cards - see below) or the ability to pay (weakening consumer) can have a material impact on the net adds for Netflix. Visibility into voluntary vs. involuntary churn is high, even if drivers are less clear: We understand there is skepticism regarding the cited credit card migration impact on Netflix churn in the quarter, and we believe visibility into the causes of involuntary churn are in fact low. However, visibility into voluntary churn (a member is cancelling) versus involuntary churn (the credit card payment or member renewal is denied) is quite high. While all churn increases are concerning given the growth expectations for Netflix, this quarter's slightly higher than expected involuntary churn (potentially driving +15-20bp impact on an estimated ~3% total domestic streaming monthly churn) does not concern us. Changes to our forecast are minimal (see Exhibit 3 to Exhibit 5): 5 Other than updating for 4Q guidance, the ripple effect of the quarter and guidance into our long-term estimates is small. Our 2016 revenue falls ~1% to $8.45bn, and our EBIT falls to ~$330mm largely due to higher tech and development + G&A costs. We continue to see 2020 global streaming subs (ex-china) of 135mm, with 60mm in the U.S. and 75mm internationally. No change to bull/base/bear targets of $170/$135/$80. Payment method problems contributed to the higher than expected involuntary churn in 3Q in the U.S. Netflix cited the migration to chip-based credit cards, particularly the push at quarter end to convert merchants over, as a factor impacting credit card payments and member renewals. However, we think this comment was aimed to provide some color to what was likely a material but not exclusive driver of the elevated involuntary churn. Visibility into the drivers of involuntary churn are likely low. Our best guess is 50-75% of the higher than expected, but still down YoY, involuntary churn was due to this issue. According to our global payments analyst, the EMV payment card migration was officially October 1, 2015. We estimate that migration was approximately ⅓ complete by YE14, with YE15 completion around 60% and ramping up to over 95% by YE17. Potential issues that could impact online payment methods throughout this process include any change in either the card number, CVV/CVC, or expiration date upon reissuance. However, we believe that for the majority of cards reissued, both the card number and CVV remain the same. 2

Risk Reward We see upside to NFLX shares at current valuation levels Source: Thomson Reuters (historical share price data), Morgan Stanley Research estimates Price Target $135 Our $135 PT reflects our base case DCF valuation and ~12x EV / 2025 base case EBITDA discounted back to year-end 2016 Bull $170 ~12.5x EV / 2025E bull case EBITDA discounted back, or based on our bull case DCF valuation Base $135 ~12x EV / 2025E base case EBITDA, discounted back, or based on our base case DCF valuation Bear $80 Based on our bear case DCF valuation Successfully leveraging investments to drive sub growth, reaching 210M global streaming subs by 2025 (ex-china). Domestic streaming subs grow to 45M by YE15 and reach 65-70M in 2020E, followed by 70-75M in 2025E. Domestic streaming contrib. margins expand slightly faster vs. our base case, reaching 45-46% in 2020. Total int'l subs (ex-china) reach ~85M by 2020E and ~135M by 2025E on successful penetration of newer markets. Buybacks begin in 2017, with long-term gross leverage at ~3x. Domestic subs reach 65-70M and international subs (ex- China) grow to nearly 110M by 2025E. Domestic streaming contribution margins expand ~350bp in '16E, followed by ~200bp p.a. thereafter towards 44% in 2020E. Internationally, NFLX s expansion drives non-u.s. subs (ex-china) to 75M in 2020E and nearly 110M by 2025E, reflecting ~25% penetration of broadband HHs in existing + developed markets and ~5% in emerging markets. Blended international contribution margins improve, leading to positive int'l contrib. margins in '18E. NFLX begins buybacks in 18E, with long term gross leverage at ~2.5x. Elevated churn domestically and challenging penetration into international markets. Total domestic streaming net adds decelerate to +1-2M in 2016 as the price increase takes effect for existing subscribers, with modest sub growth thereafter to 55M by 2025E. Domestic ARPPU reaches ~$10/month in 2017E with limited growth thereafter towards $12 by 2025E, and longer-term domestic contribution margins expand just +150bps annually on average. International streaming subs grow to 65-70M by YE2020 due to slower growth in tougher markets. Int l contribution margins are ~300bp lower than our base case in '16-'18E on average. Why Overweight? We believe share performance is highly dependent on increasing global membership scale. Proven success in the US and initial int l markets provides a roadmap to success in new markets, and scale should allow NFLX to leverage content investments and drive margins. Higher global broadband penetration should increase NFLX s addressable market, driving member growth and providing further opportunity for new market launches Longer term we see the ability to drive ARPPU growth, particularly given increased confidence in original programming traction Key Value Drivers Domestic subscriber growth and contribution margins International subscriber growth and performance in recent and upcoming markets (launched in Germany / France in September 2014, Australia / New Zealand in early 2015, Japan in September, and Spain, Italy, Portugal, in Oct. 2015) Impact of announced pricing increases on member churn through 2016 Ability to maintain exclusive content offering to differentiate product from competitors, and to a lesser extent, success of original programming Potential Catalysts Further integration with MVPD offerings Success in international markets Success of original programming Announcement of long-term agreements securing exclusive quality content Risks to Achieving Price Target Pricing increases drive elevated churn Increased competition drives higher pricing for exclusive content lowering margins Challenges in newer markets negatively impacts member growth expectations 3

3Q15 Actuals and 4Q15 Guidance vs. MSe Exhibit 1: Netflix 3Q15 Actuals vs. MSe 4

Exhibit 2: Netflix 4Q15 Guidance vs. MSe 5

Changes to our estimates and bull, bear, base scenarios Exhibit 3: NFLX: Prior vs. Current for 4Q15E Source: Morgan Stanley Research estimates. NM =Not meaningful 6

Exhibit 4: NFLX: Prior vs. Current for FY16E 7

Exhibit 5: NFLX: Prior vs. Current for FY17E 8

Exhibit 6: Netflix Base, Bear, and Bull Scenarios 9

Exhibit 7: Netflix Fair Market Value 10

Exhibit 8: Netflix DCF Analysis 11

Exhibit 9: Netflix Free Cash Flow Analysis Netflix, Inc. Model (USD millions) 2014 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E Free Cash Flow Reported EBITDA $456.7 $358.5 $399.5 $1,083.8 $2,054.4 $3,097.2 $4,193.7 $5,258.5 $6,347.5 $7,497.0 $8,747.3 $10,101.5 Cash Interest Expense (53.3) (157.8) (133.1) (141.4) (208.4) (344.6) (489.4) (640.9) (792.2) (937.4) (1,098.0) (1,296.4) Cash Taxes (112.6) (118.4) (74.0) (327.9) (668.3) (1,010.1) (1,369.1) (1,713.5) (2,067.3) (2,446.5) (2,858.1) (3,294.9) Cash Spent on Programming (in Excess of Amort) (524.1) (1,194.2) (1,419.9) (882.3) (670.8) (501.6) (451.4) (409.8) (363.0) (293.9) (234.0) (160.8) Acqusition of DVD content library (net of Amort) (3.3) (3.9) - - - - - - - - - - Capex (69.7) (94.9) (97.7) (100.7) (103.7) (106.8) (110.0) (113.3) (116.7) (120.2) (123.8) (127.5) Working Capital 137.1 238.8 145.5 110.0 77.4 72.9 66.6 63.1 59.4 61.2 61.4 64.6 Minority Interest - - - - - - - - - - - - Free Cash Flow ($169.2) ($972.0) ($1,179.8) ($258.5) $480.5 $1,207.0 $1,840.5 $2,444.1 $3,067.6 $3,760.2 $4,494.8 $5,286.5 Growth 474.4% 21.4% -78.1% -285.9% 151.2% 52.5% 32.8% 25.5% 22.6% 19.5% 17.6% Average Fully Diluted Shares 431.9 441.8 446.3 450.9 447.2 433.8 417.8 400.3 382.2 364.0 344.5 322.8 FCF per Share ($0.39) ($2.20) ($2.64) ($0.57) $1.07 $2.78 $4.41 $6.11 $8.03 $10.33 $13.05 $16.38 Growth 20% -78% NM 159% 58% 39% 31% 29% 26% 26% EBITDA Multiple Valuation EV/fwd EBITDA 144.7x 141.5x 56.9x 32.7x 23.6x 19.0x 16.5x 14.9x 13.8x 12.9x 12.2x EV/fwd unlev fcf 72.5x 40.5x 30.0x 25.0x 21.9x 19.6x 18.0x 16.7x EV $51,865.1 $56,530.6 $61,615.9 $67,158.6 $73,199.8 $79,784.6 $86,961.6 $94,784.3 $103,310.6 $112,604.0 $122,733.3 Net Debt ($708.5) $82.2 $1,119.7 $1,213.8 $3,554.1 $6,055.0 $8,692.2 $11,418.3 $14,049.9 $16,571.8 $19,651.6 YE equity value $52,573.6 $56,448.4 $60,496.2 $65,944.8 $69,645.7 $73,729.5 $78,269.4 $83,366.0 $89,260.7 $96,032.2 $103,081.7 YE Shares Out 439.7 444.0 448.6 453.2 441.3 426.3 409.4 391.3 373.2 354.8 334.3 Implied NFLX Equity Value $120 $127 $135 $146 $158 $173 $191 $213 $239 $271 $308 Implied Fwd FCF Multiple 135.4x 56.7x 39.3x 31.3x 26.5x 23.2x 20.7x 18.8x Fwd. FCF/ Share ($2.20) ($2.64) ($0.57) $1.07 $2.78 $4.41 $6.11 $8.03 $10.33 $13.05 $16.38 WACC 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 12

Exhibit 10: Netflix Multiples Analysis 13

Exhibit 11: Netflix Annual International Subscriber Forecast 14

Exhibit 12: Netflix Quarterly Operating Forecast 15

Exhibit 13: Netflix Annual Operating Forecast 16

Exhibit 14: Netflix Annual Content Obligations and Amortization 17

Exhibit 15: Netflix Quarterly Income Statement 18

Exhibit 16: Netflix Annual Income Statement 19

Exhibit 17: Netflix Annual Balance Sheet 20

Exhibit 18: Netflix Annual Cash Flow Statement 21

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COVERAGE UNIVERSE INVESTMENT BANKING CLIENTS (IBC) STOCK RATING CATEGORY COUNT % OF TOTAL COUNT % OF TOTAL IBC % OF RATING CATEGORY Overweight/Buy 1217 36% 348 44% 29% Equal-weight/Hold 1441 43% 344 44% 24% Not-Rated/Hold 91 3% 8 1% 9% Underweight/Sell 619 18% 89 11% 14% TOTAL 3,368 789 Data include common stock and ADRs currently assigned ratings. Investment Banking Clients are companies from whom Morgan Stanley received investment banking compensation in the last 12 months. Analyst Stock Ratings Overweight (O). The stock's total return is expected to exceed the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Equal-weight (E). The stock's total return is expected to be in line with the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Not-Rated (NR). Currently the analyst does not have adequate conviction about the stock's total return relative to the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Underweight (U). The stock's total return is expected to be below the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months. Analyst Industry Views Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark, as indicated below. In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark, as indicated below. Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark, as indicated below. Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index; Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index or MSCI sub-regional index or MSCI AC Asia Pacific ex Japan Index. Stock Price, Price Target and Rating History (See Rating Definitions) 23

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INDUSTRY COVERAGE: Media COMPANY (TICKER) RATING (AS OF) PRICE* (10/14/2015) Benjamin Swinburne, CFA 21st Century Fox (FOXA.O) O (08/05/2014) $28.55 CBS Corporation (CBS.N) O (07/20/2009) $42.43 Discovery Communications (DISCK.O) E (07/20/2009) $26.58 Interpublic Group (IPG.N) E (01/11/2013) $20.85 Lamar Advertising Co. (LAMR.O) E (07/30/2014) $55.04 Netflix Inc (NFLX.O) O (06/17/2014) $110.23 Omnicom Group Inc. (OMC.N) E (05/28/2014) $70.87 OUTFRONT MEDIA INC (OUT.N) E (07/30/2014) $22.78 Pandora Media Inc. (P.N) E (06/18/2014) $19.90 Scripps Networks Interactive (SNI.N) U (01/25/2013) $55.22 Time Warner Inc. (TWX.N) E (01/20/2015) $71.03 Viacom (VIAB.O) U (01/20/2015) $47.08 Walt Disney Co (DIS.N) E (09/19/2013) $105.73 Ryan Fiftal AMC Networks, Inc. (AMCX.O) O (08/03/2015) $72.83 Cinemark Holdings, Inc. (CNK.N) E (04/23/2014) $34.67 Dreamworks Animation SKG, Inc. (DWA.O) O (11/26/2014) $20.51 Madison Square Garden Co (MSG.N) O (03/30/2015) $175.03 Regal Entertainment Group (RGC.N) E (02/04/2015) $19.36 Starz (STRZA.O) E (08/03/2015) $38.60 Tribune Media Company (TRCO.N) E (08/19/2015) $38.02 Stock Ratings are subject to change. Please see latest research for each company. * Historical prices are not split adjusted. INDUSTRY COVERAGE: Internet Media COMPANY (TICKER) RATING (AS OF) PRICE* (//) Stock Ratings are subject to change. Please see latest research for each company. * Historical prices are not split adjusted. 2015 Morgan Stanley 26