Netflix (NFLX) has beaten its own low guidance for third-quarter subscriber adds in both the international (3.20 million net adds, versus guidance of 2.0 million) and U.S. segments (0.37 million net adds, versus guidance of 0.4 million), owing to new customer interest in original content. The company also issued weak U.S. subscriber guidance for the fourth quarter (1.45 million), as management expects some continued impact from grandfathering. Revenue and adjusted operating income were slightly ahead of our expectations. Netflix continues to expand its streaming base, ending the quarter with more than 83.3 million global paid subscribers, up from 66 million a year ago. We retain our narrow moat rating and our $69 fair value estimate. With shares trading in 2-star territory, investors should wait before putting new money to work.
As we discussed in our note last quarter, U.S. net adds continue to decline more quickly than previously expected, with year-to-date paid net adds of 3.08 million, down 30% from 4.37 million over the same period in 2015, which was 4% below the first nine months of 2014. While we projected subscriber net add growth to gradually decrease, the current results and low guidance are surprising, given the 2.31 million paid net adds in the U.S. in the first quarter. The current guidance for 1.45 million total net adds implies a 25% annual decline in total net adds. While we currently model a 10% average annual decline in total net U.S. from 2017 to 2020, with a 19% decrease in 2017, our projections (and consensus) may prove optimistic and problematic for the company. If management is correct that outperformance in the third quarter stemmed from consumer excitement around original content and issues with grandfathering drove the weak second-quarter performance, Netflix will need to keep ramping up its investment in original content at the expense of acquired content, without being able to rapidly increase its monthly fee, increasing pressure on margins.
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