Netflix Inc. (NFLX) released its third quarter earnings report on Oct. 20. To the disappointment of its investors, the streaming content giant once again fell short of analysts' expectations.
As Netflix's vaulting valuation is justified by a narrative of massive future growth, the slowdown in net subscriber adds was especially disconcerting for bullish investors. With management conceding that this slowdown is likely to continue into the fourth quarter, Netflix could soon find its stock under intensified pressure.
Subscriber growth disappoints
Things were already looking dicey for Netflix after reporting second quarter earnings on July 16. The company added 10 million net paid subscribers, which, while impressive in absolute terms, was well below Wall Street predictions of 12 million to 15 million. Netflix further salted the wound by cutting its third quarter guidance in half, from 5 million to 2.5 million. As the third quarter played out, some observers feared Netflix might fall short of even this lowered bar. I predicted as much in an Oct. 2 article for GuruFocus.
My suspicion was validated by Netflix's latest quarterly update, which showed subscriber growth falling short of internal guidance as well as the Wall Street consensus. In the end, the company gained 2.2 million paid subscribers, missing the already halved guidance from the prior quarter.
Of course, no one was expecting a repeat of the previous two quarters, which saw record subscriber growth thanks to widespread economic lockdowns creating a strong "pull forward" effect. Still, investors had hoped for slightly more in the third quarter than Netflix was able to deliver.
Putting on a brave face
At the end of the third quarter, Netflix boasted 195.2 million global paid subscribers, 23% more than it had at the same time last year, and far more than any other streaming service can yet boast. Still, the company was clearly eager to downplay the subscriber growth miss in its letter to shareholders:
"We continue to view quarter-to-quarter fluctuations in paid net adds as not that meaningful in the context of the long-run adoption of internet entertainment, which we believe is still early and should provide us with many years of strong future growth as we continue to improve our service."
Netflix has certainly seen solid overall growth over the course of the past several years, so management's admonition to think about the long term has some validity. However, there is clearly a lot of growth expectation already baked into the company's $214 billion market capitalization. A secular slowdown in subscriber growth could threaten that.
More trouble on the horizon
Netflix's subscriber growth trend is unlikely to reverse course anytime soon, in my estimation. Indeed, the company is now guiding for a year-over-year decline in subscriber growth in the fourth quarter. In the final three months of 2019, Netflix added 8.8 million subscribers. It expects to add just 6 million in the fourth quarter this year.
Netflix has also struggled in recent quarters to maintain its growth narrative in the face of slowing subscriber growth. With the U.S. and Canada looking increasingly saturated, international markets have become key to Netflix's growth story. But signs of slowing growth in other markets are also beginning to appear. In Latin America, for example, Netflix added 1.5 million subscribers in the third quarter of 2019. This year, it managed to add just 260,000 in the same period – another chink in the armor of the Netflix growth narrative.
My assessment
Wall Street analysts are still grappling with the ramifications of Netflix's latest guidance, but the reality of slowing subscriber growth is forcing many to rethink their long-term growth forecasts. Consequently, it is my view that Netflix's share price will face mounting pressure over the next year, with valuation multiple compression increasingly likely. My recommendation is to steer clear of this overvalued name.
Disclosure: No positions.
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