Fraud Claims Against Netflix Over Customer Attrition Dismissed

A California federal judge has dismissed consolidated securities fraud suits against popular online DVD rental service Netflix Inc. after finding investors could not show the company used improper methods to calculate its subscriber attrition rate.

The investors had sued Netflix when release of the second-quarter results in July 2004 spurred a one-day drop in share price of 28 percent.

The previous October the company had announced that it ended the third quarter of 2003 with a subscriber base of 1.291 million and a growth of 74 percent over 2002. Netflix increased its earnings expectations for the next quarter and lowered the monthly subscriber churn rate from 4.9-5.4 percent to 4.7-5 percent. The churn rate is an estimate of the number of subscribers who will not renew.

When the company announced its earnings expectations for the year in February 2004, Netflix downgraded the anticipated rate of churn to between 4.3 percent and 5.1 percent.

But when Netflix posted results for second-quarter 2004, the company reported a churn rate of 5.6 percent for that quarter, and its share price declined 28 percent from $32 to $23.02.

Investors sued alleging violations of the antifraud provisions of federal securities laws. The suits also named Netflix CEO Reed Hastings, CFO W. Barry McCarthy Jr. and CMO Leslie J. Kilgore as defendants, asserting they had respectively sold $12.7 million, $135,000 and $2 million worth of their holdings before the increased attrition rate was disclosed.

In addressing the dismissal motions filed by the defendants, U.S. District Judge Fern M. Smith of the Northern District of California said the core of the plaintiffs' allegations went to the question of the propriety of the method Netflix employed to calculate subscriber churn.

The plaintiffs said the Netflix calculation overemphasized subscriber additions and eliminated the effect of cancellations. The investors maintained that churn should be calculated by adding the number of subscribers at the beginning of the quarter to the number of subscribers at the end of the quarter and dividing by two. This methodology would reflect churn rates 25 to 30 percent higher than the Netflix estimates.

But the court found the investors "offer no authority for the proposition that their method is proper and Netflix's method is improper."

The court said the plaintiffs concede that no official methodology exists for calculating churn.

"Importantly, Netflix clearly and repeatedly disclosed its formula for calculating churn," the court said. "Even in the financial reports in which the number of subscriber cancellations was not expressly disclosed, this number could be calculated through simple arithmetic using other numbers that were disclosed."

Beyond finding that the investors had insufficiently alleged a false or misleading statement, the court further agreed with the defense that they had failed to adequately plead an intent to deceive.

In considering the alleged stock sales made during the class periods by Hastings, McCarthy and Kilgore, the judge noted that these sales represented only 7.5 percent, 1 percent and 15.7 percent of their respective holdings in Netflix.

"Under 9th Circuit law, these percentages are not inherently suspicious," Judge Smith said.