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IN RE NETFLIX

November 18, 2005.

IN RE NETFLIX, INC. SECURITIES LITIGATION.


The opinion of the court was delivered by: WILLIAM ALSUP, District Judge

CLASS ACTION

DISMISSAL ORDER

INTRODUCTION

  INTRODUCTION

  In this securities-fraud case, defendants move for dismissal of plaintiffs' first amended consolidated complaint (hereinafter "complaint") and for judicial notice of certain documents. The request for judicial notice is unopposed and is GRANTED. Because plaintiffs have failed to allege any false statements or material omissions, the motion to dismiss for failure to state a claim is GRANTED. Leave to amend previously being allowed, the case is over at the district court. This time the dismissal is without leave to amend.

  STATEMENT

  Lead plaintiffs are four investors who purchased publicly traded shares of securities in Netflix, Inc., a corporation based in Los Gatos, California, that sold monthly subscriptions allowing people to order DVDs on the Internet and to receive them by mail.

  They allege that they purchased shares at prices that were inflated by fraud committed by Netflix and three of its officers: Reed Hastings, chief executive officer and board of directors chairman, Barry McCarthy, chief financial officer and secretary, and Leslie Kilgore, chief marketing officer and marketing vice president.

  Lead plaintiffs claim that from April 17, 2003, to October 14, 2004, defendants made false and misleading statements, and failed to disclose material facts required to make their other statements not misleading. They allege such statements came in press releases issued on wire services, in Securities and Exchange Commission filings, in public presentations and in telephone conference calls with investors and analysts. They charge defendants with using a misleading calculation of the average subscriber cancellation rate, also called "churn." That metric was in turn used to calculate other financial measures. Plaintiffs allege that investors relied upon these measures in overvaluing the securities. Defendants do not contest that the measures are material. The contested measures made Netflix appear to be viable. In fact, say plaintiffs, the company's business model was broken.

  1. JUDICIAL NOTICE.

  Defendants have asked for judicial notice of certain SEC filings, calculations based upon information in those filings, Netflix press releases and a publication on churn published by the audit firm KPMG and referenced in the complaint (Defs.' Req. for Judicial Notice).

  A court must take judicial notice of adjudicative facts if a party requests that it do so, supplies the necessary information to decide the request and the facts are "not subject to reasonable dispute" because they are "capable of accurate and ready determination by resort to sources whose accuracy cannot reasonably be questioned." FRE 201 (a), (b), (d).

  The time has passed for plaintiffs to raise objections to defendants' request. They have not done so. Defendants have met the FRE 201 requirements. The documents are relevant to the complaint. This order therefore takes notice of those facts.

  2. PUBLIC STATEMENTS BEFORE THE CLASS PERIOD.

  As Netflix was preparing to make its initial public offering of securities, it notified the SEC on April 16, 2002, that "an average of approximately 8% of [] total subscribers cancelled their subscriptions each month" in the twelve-month period that had ended March 21. It repeated that statement to the SEC on May 6. Two weeks later, the company reported a similar cancellation rate for calendar year 2001. It further stated that for the first quarter of 2002, the cancellation rate per month was about seven percent, down from about ten percent in the first quarter of 2001. Netflix repeated most of these statements in its IPO Prospectus filed May 23, 2002 (Compl. ¶¶ 92, 94, 95). In these statements, the corporation provided no definition of "total subscribers."

  On July 24, 2002, the company released a statement that churn had declined to 6.7 percent. In an endnote linked to the first mention of churn, the term was defined as "a monthly percentage determined by subtracting from one, a quotient, the numerator of which is the ending subscribers for the current quarter and the denominator of which is the sum of the previous quarter's ending subscribers plus the current quarter's new trial subscribers and then dividing this resulting number by 3, which is the number of months in the quarter." That formula was repeated in the corporation's quarterly SEC filings for the second and third quarters of 2002 (Hoffman Decl., Exhs. A, B, G).

  3. ALLEGED FRAUD DURING THE CLASS PERIOD.

  The first allegedly false statement made during the class period came April 17, 2003, when the company announced that its first quarter 2003 churn rate was a "record low" of 5.8 percent, down from 7.2 percent a year earlier (Hoffman Decl., Exh. H). The release also stated that "implied subscriber lifetime" — the average duration of subscriptions — was defined as the inverse of the reported churn rate.[fn*] The release's tabular material containing the churn rate purportedly was "unaccompanied by, and was not preceded by, any definition of how the churn rate was calculated" (Compl. ¶¶ 104-05). That claim is untenable. The July 24, 2002, press release and the quarterly reports for the second and third quarters of 2002 each disclosed how churn was determined. This order takes judicial notice of those documents.

  Also on April 17, Hastings and McCarthy spoke by conference call with analysts. Hastings touted the company's "lowest churn rate in [its] history," repeated the churn statistics for the quarter, stated that the decrease was related to improving customer satisfaction and credited the low churn rate with playing a central role in "enabling [Netflix] to build a bigger and more profitable business." He also stated that customer retention "is the just the numeric inverse on churn." McCarthy stated that the churn rate was one of the "trinity of metrics" guiding Netflix to financial success (Compl. ¶ 106).

  This news propelled average share price twenty percent higher over the next two days, to $24.63, on volume five times its normal level (Compl. ¶ 112).

  Hastings repeated the churn-rate figures in a public presentation at the Wharton School of Business at the University of Pennsylvania on May 1, 2003, and three days later by Netflix in its first-quarter SEC report. Tabular material in that filing included a line listing the churn rate followed, on the next line, by the average number of paid subscribers during the quarter. The latter line was indented so that it appeared to be a sub-component of the churn rate. No definition of churn was given (Compl. ¶¶ 115, 117).

  On July 17, 2003, Netflix announced that its churn rate was 5.6 percent in the second quarter. The term "churn" was followed by a superscript numeral that led readers to an endnote definition identical to earlier ones. Again, Hastings and McCarthy spoke by conference call with analysts and touted the importance of declining churn (Compl. ¶¶ 119, 120, 122).

  On October 15, 2003, Netflix announced another churn-rate decline, to 5.2 percent, and again defined the term. This time, it was defined "as customer cancellations in the quarter divided by the sum of beginning subscribers and gross subscriber additions, divided by three months." This definition is functionally identical to the more formal one given earlier. Hastings and McCarthy hailed the results in a quarterly conference call. Hastings said good service drove churn down. McCarthy called churn a "primary driver[]" of financial performance," and partly attributed its decline to an increase in the number of movies Netflix's offered for rental (Compl. ¶¶ 124, 126).

  In an interview October 23, 2003, Hastings was asked by The Motley Fool magazine how long the "median customer is maintaining his Netflix membership?" Hastings responded by stating that the "mean customer life" was "roughly one divided by the churn," a definition identical to that previously applied to "implied subscriber lifetime" (Compl. ¶ 129). On January 21, 2004, the company announced the churn had fallen to 4.8 percent in the fourth quarter of 2003. It repeated the definition of churn (Hoffman Decl., Exh. J). This achievement was trumpeted in a conference call to analysts. On March 1, the company repeated these results and the churn definition in ...


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